Look at it any way you like, US equities are looking expensive in relation to longer-term comparisons but are relatively cheap when compared with valuations over the last 10 years. And this is not surprising because there is a good deal of uncertainty over possible trends going into the new year.
The cyclically adjusted price-earnings ratio (Cape) developed by Robert J Shiller of Yale University, which is defined as the ratio of the inflation-adjusted S&P 500 index to the average of the past 10-year S&P 500 annual earnings, is standing at around 21.4 compared with an historical average of 16.4. However, barring the first quarter of 2009, when the ratio fell below 15, the reading is at the lower end of the range for the past 10 years. So, yes, the S&P is expensive on a long-term basis and inexpensive in relation to the last decade.
Conflicting signals
The fact that the performance record is throwing off conflicting signals is both unhelpful and yet unsurprising, given the unprecedented conditions in financial markets. Fundamental analysis and trends can tell us a lot, but there is no precedent when it comes to the Federal Reserve putting an extra $600bn (£381bn) into the economy by the middle of next year, by buying back US Treasury bills, irrespective of whether such a move works to kick-start the US economy.
There will also be an additional $120bn stimulus now that President Obama has agreed to the extension on the Bush-era tax cuts, and further intervention from the Fed as it reinvests dividends accrued on the Treasury bills it holds to buy more Treasury bills – perhaps as much as $400bn.
And this uncertainty has led to a pretty clear divergence on predicted equity performance, although oddly enough the divergence is not in the direction but in the timescale. For example, John Hussman, president of Hussman Funds, reckons that investors in US equities are likely to achieve poor returns over the coming five to seven-year period, with total annual return of minus 0.07 per cent. This is based on the current 2 per cent yield on the S&P 500 index compared with long-term growth in dividends rates over the past 70 years of 6 per cent and a median dividend yield of 3.7 per cent since World War II.
However, Barclays Capital has adopted a more sanguine view, although analysts are quick to point out that the current pace of year-on-year S&P 500 operating earnings growth of 44 per cent to the start of November is clearly unsustainable, and they expect this to slow to 7 per cent for 2011. Around 40 per cent of S&P 500 earnings are generated from outside the US, and while corporate profits will benefit from a weak dollar and a subsequent boost in exports to emerging economies, there are significant headwinds within the US, not least of which is the stubbornly high unemployment rate and the depressed housing market. BarCap is forecasting a 2011 year-end level for the S&P 500 index of 1250, which would put the index on a prospective PE ratio of 14. With the index currently trading at 1210, this implies only modest growth.
Near-term concerns
But there may be storm clouds in the short term, notably in the first quarter of 2011. Sentiment at the moment has been positive because the Fed is flooding the market with cheap money, while a change in the political situation means that there will be a much more effective squeeze on central government spending – both bullish signals. However, consumer and public sector deleveraging, an unsustainable fiscal position, sovereign debt worries in Europe, and inflationary concerns in countries such as China suggest that the first quarter may see equities struggling to make any headway at all. But the negative aspects of all these, irrespective of whether they quickly come to fruition, are currently not enough to offset the positive forces of the so-called QE2 asset purchase programme and an improving economic outlook.
Longer-term strength
The message for potential investors is that the first quarter is sufficiently cloudy as to make any particular investment decision difficult. But unless the current factors stacked up on the negative side start to grow in size or multiply, there is still sufficient momentum to support continued corporate earnings growth, BarCap adds.
And this is much the same view adopted by Henry Dixon, fund manager at Matterley, part of the Charles Stanley Group. "US equities command a 20 per cent premium on most valuation metrics when compared with European equities," he says. The primary reason for that is the near certainty that the US economy will pull out of the economic downturn before any other major industrialised country. And, unlike European equity markets, there is full political support for US equity markets, adds Mr Dixon.
This matters greatly because, while US growth may slow, corporate profitability will be boosted by a strong export performance, thanks in part to a weaker dollar. And yet it is hard to ignore some of the basic factors that still point to the downside. True, US exports could grow, but these form a tiny part of GDP. Consumer spending in its various guises accounts for much more, around two-thirds of GDP, and consumer confidence is being constrained by weakness in the housing market and a subdued employment market. The economy has to add at least 100,000 jobs each month just to keep up with the increase in population, and it has struggled to do this, which is why nearly one in 10 workers remain unemployed. Durable goods orders and orders for new capital equipment are also falling, while new home sales slid 8.1 per cent in October alone.
But none of this matters if investors stick with the view that US equities will emerge from the credit crunch-related economic downturn first. However, you are going to have to be selective about which sectors to avoid. Earnings across the S&P 500 are forecast to climb 13.5 per cent in 2011, according to a consensus forecast complied by Bloomberg. Average earnings per share are forecast to touch $96.43, well above the previous high of $91.47 hit in mid-2007. Companies with a strong export bias will profit from a weak dollar while consumer discretionary stocks are expected to face greater pressure. This is because consumers will be more cash conscious, while low inflation will restrict companies' ability to pass on the rising cost of imported materials. For some the squeeze has already arrived. Third-quarter sales at Kraft, for example, fell short of expectations after it increased prices to try and offset higher ingredient costs.
So, the overall picture remains relatively upbeat for US equities. Dan Morris, global strategist at JPMorgan Asset Management sums it up like this. "Quantitative easing in the US should provide the fuel for equity and high-yield debt rallies in the US, but also in emerging markets, as investors look abroad for better yields and growth prospects. If underlying economic growth in the US doesn't improve, however, the risk is for unsustainable increases in asset prices and rising inflation. Depreciation of the dollar should help to reorient US domestic demand towards the national economy and away from imports, however, helping to reduce one of the larger global imbalances that initially precipitated the credit crisis."
