Pricey US stocks could keep marching higher

However, many measures now suggest US equities are expensive. According to the cyclically adjusted price-to-earnings ratio (PE), valuations in the US market have only been as high in 1929 shortly before the Wall Street crash and in the late 1990s before the dot com bubble burst. So, should investors be steering clear, or does the bull market have further to run?

Bull markets don’t die of old age

“While valuations are high, they have been for some time and markets can remain overvalued or undervalued for extended periods,” says Adrian Lowcock, head of personal investing at Willis Owen. “Market peaks are created not by overvaluation but by an event or situation that causes investors’ perspectives to change, making them lose confidence or become fearful.”

And though there are plenty of reasons to be nervy – such as trade and geopolitical tensions – these are currently leading to increased demand for US assets, as investors switch from higher risk areas like emerging markets.

Mark Sherlock, head of US equities at Hermes Investment Management, adds: “We do not believe [the length of the bull market] automatically signifies the next US recession is imminent. The underlying domestic economy is healthy, with 4 per cent gross domestic product (GDP) growth in the second quarter, low levels of unemployment, high consumer and corporate optimism, double digit earnings growth- based on underlying demand - not just [President Trump’s] tax cuts - and a sharp pick up in business investment.

"Interest rates remain low and are forecast to rise at a modest, steady pace. This has been well telegraphed to the market. While monetary conditions remain reasonably loose, continued economic growth appears supported.”

And finding companies with good free cash flow is easier in this environment, suggests Richard Nackenson, manager of Neuberger Berman US Multi Cap Opportunities Fund (IE00B7XCGB41), as company balance sheets are healthy and management teams can allocate capital effectively.

US corporates are also producing strong earnings growth. Average earnings growth for the S&P 500 index was 25 per cent in the second quarter. If earnings growth outpaces share price growth it dampens valuations and this is a trend the market has seen this year. As a result, compared to the start of this year valuations have fallen on a price to earnings (PE) basis.

It is this situation which could give the bull market a second wind but with a slightly different dynamic, according to Mr Lowcock. So far returns have been driven by growth stocks, and specifically tech stocks. Under-priced value stocks have yet to have their time in the sun.

"The bull market could continue for some time if there is a rotation from growth to value," he says.

This shift could happen if there is a pick-up in inflation driven by wage inflation. The latest figures show that annual US wage growth hit a nine-year high as the economy created more jobs than expected. Unemployment is already at very low levels of 3.9 per cent. “Increased inflation could hit the margins of growth stocks and their share prices, and this would allow value-style companies to outperform,” says Rob Burdett, co-head of the BMO Global Asset Management multi-manager team.

Also investor worries about the bull market coming to an end mean it could have further to run.

“The euphoria that typically marks the end of a bull market is notably absent this time,” explains Tom Stevenson, investment director for personal investing at Fidelity International.

Known and unknown risks

But the question remains as to whether US equities offer good value, particularly at this late stage in the cycle. And high valuations of tech stocks are causing some investors concern.  

“Valuations may be worse than they look because US tax cuts have flattered the pace of earnings growth, and if you look at the trailing PE it is higher than it was at the top of the market in 2007,” adds Marcus Brookes, head of multi-manager at Schroders.

“It’s not just PEs reflecting high valuations. The price-to-book valuation is at its highest level since the dot com boom and the price-to-sales ratio for the US is at a record level. That’s why strong economic growth is needed [to justify these valuations]. The problem is that the backdrop is actually one where the economic cycle growth rate has probably peaked. We have trade disputes, and monetary tightening in the form of central bank stimulus being removed or interest rates being raised. It’s far from the perfect mix of conditions.”

For this reason, he thinks that less volatile assets such as cash could be attractive. “It’s noteworthy that US government bonds, in the form of three-month Treasuries, yield a little over 2 per cent (as of 22 August) more than the US stock market,” he adds. 

Investors should watch out for a potential inversion in the yield curve, something that came close to happening in the US bond market in August. An inversion in the yield curve happens when short-term government bonds have a higher yield than long-term government bonds, indicating that investors anticipate a slowdown in the near future. According to Bloomberg, as of 7 September, US two-year Treasuries yield 2.7 per cent, compared to US 10-year Treasuries which are yielding 2.94 per cent.

“Not all economic slowdowns have been preceded by an inversion of the US yield curve, but historically this has been one of the most reliable indicators of a forthcoming decline of American growth,” says Tommaso Mancuso, head of multi asset at Hermes Investment Management.

An unexpected event causing share prices to fall is also a possibility, especially given the current tumultuous political environment. For example the possibility of US President Donald Trump being impeached may increase if the Democrats win control of the Senate in the mid-term Congressional elections in November. Or a Democrat controlled Senate could make it more difficult for the Trump administration to push through further tax cuts or business-friendly policies.

“US stocks do not live in an ivory tower, there are plenty of risk factors that could trigger a decline, it’s just that the market is not focusing on these issues right now,” argues Kathleen Brooks, research director at Capital Index. However, this might change in the next few months she suggests. For example, the two additional interest rate rises the market is anticipating this year could herald difficulties.

“With the cost of capital rising dramatically in 2018, how long can US stocks continue to march higher before the prospect of rising interest rates causes the economy to cool and stock markets to sell-off?” Ms Brooks asks.

Funds for US exposure

Given the potential risks in the US, Mr Burdett thinks Artemis US Extended Alpha Fund (GB00BMMV5G59) is a good option. The fund’s manager, Stephen Moore, has a flexible approach and as a long/short fund, Artemis US Extended Alpha combines a portfolio of stocks whose share prices are expected to rise, with a portfolio of short positions – where the aim is to profit from falls in share prices. This means the fund has the potential to profit from falling markets as well as rising markets, although this is dependent on the manager making the right calls. However, since its launch in September 2014, the fund has outperformed the S&P 500 index, achieving a return of 113.7 per cent, compared to 90.5 per cent for the index. Artemis US Extended Alpha Fund has an ongoing charge of 0.82 per cent, plus a performance fee.

Another fund that has succeeded in beating the S&P 500 index is Baillie Gifford American (GB0006061963), run by Tom Slater, Gary Robinson, Helen Xiong and Kirsty Gibson. Over the past 10 years it has delivered 394.8 per cent compared to 266.5 per cent for the S&P 500. The fund was also the best performing fund in the Investment Association (IA) North America sector over one, three and five years.

The managers run a concentrated portfolio of between 30–50 stocks. They aim to find growth businesses and own them for long enough for the business models to become the driver of returns rather than bull markets. They take a five-year view when investing in stocks and have a low turnover - which is currently 15 per cent. The fund differs substantially from the S&P 500 index as it has an active share of 91 per cent. Its largest two sectors are information technology and consumer discretionary. It also has a low ongoing charge for an active fund of 0.52 per cent.

Baillie Gifford American’s growth-orientated style has been very much in favour for the past 10 years, but value-style investing which focuses more on finding underpriced companies has not. Investors may want to increase their value exposure, in case value-style companies start outperforming.

One way to get exposure to this theme, suggests Darius McDermott, managing director of FundCalibre, is Fidelity American Special Situations (GB00B89ST706). This fund has lagged its peers over the past few years because it has not held the big technology names but this may work in its favour if tech valuations fall. It aims to invest in companies that are undervalued, either because they are out of favour or little value is given to their recovery potential. Its manager, Angel Agudo, focuses on finding companies with strong balance sheets or resilient business models. And the fund tends to have a bias towards medium-sized and smaller companies. It has an ongoing charge of 0.95 per cent.

However, investors in the US need to acknowledge that most active managers struggle to consistently beat the market. There are so many analysts covering stocks there is little price inefficiency. So using a passive fund for your US exposure is another option. One good example is IC Top 50 ETF, iShares Core S&P 500 UCITS ETF (CSP1). This exchange traded fund (ETF) seeks to track the performance of the S&P 500, the 500 largest cap US companies. It is a strong offering in terms of size, liquidity and tracking ability, and has a competitive ongoing charge of 0.07 per cent.