Don’t buy US stocks too high
Never mind talk of “hard or soft landings”, the “US economy is picking up altitude again”, says John Authers on Bloomberg. From the labour market to manufacturing, recent data coming out of the world’s biggest economy has been “relentlessly strong”. While that is good news, it carries the risk that inflation and interest rates could both stay higher than expected.
At the start of 2024 markets were betting that the US Federal Reserve would deliver six interest rate cuts by the year’s end. That has since fallen to just two or three. The prospect of less monetary loosening ahead should weigh on stocks, but the S&P 500 index has still gained 9.5% so far this year. For now, strong corporate profits and excitement about artificial intelligence (AI) are keeping the market aloft.
The US stockmarket resembles a “runaway train” that is “rattling along… so fast” it is difficult to “hop off without breaking a limb”, says Katie Martin in the Financial Times. Investors face a conundrum – stick with a buoyant but “stretched” market or make a “heroically contrarian call”, even though betting against US stocks has been a bad strategy for years. The latter would be a mistake if the current melt-up continues. Goldman Sachs analysts calculate that the S&P could gain another 15% from here if the “megacap exceptionalism” of US technology giants persists.
An infallible market
Yet too many on Wall Street have a “glassy-eyed belief” in the infallibility of US companies, despite high prices. “It’s just harder and harder to get excited about owning the S&P 500 because of how well that index has done, how high the valuations are,” says Ben Inker of investment manager GMO.
“The longer America’s stockmarket outperforms the rest, the more it seems like the natural way of things,” says The Economist. The premium valuations that US stocks command to the rest of the world have become glaring. Take the cyclically adjusted price-to-earnings (Cape) ratio of US stocks, a popular valuation metric that smooths out performance over the economic cycle. European stocks trade on a Cape of roughly 20, with Japanese ones a little higher; the S&P is on almost 34.
It has only been higher twice before – “at the peak of the dotcom bubble, and just before the crash of 2022”. That doesn’t mean a bust is imminent, but history shows high Capes are a “strong indicator that poor or even negative long-run real returns lie ahead”. The US market has delivered a total gain of 46% since the October 2022 lows, says Tom Stevenson in The Telegraph. In historical terms, that only makes this a “baby bull”. The past 18 bull markets delivered gains of anywhere between 42% and 169%.
The current debate about valuations is a healthy sign that investors haven’t lost their bearings and given in to total euphoria yet, as they are wont to do at the market top. We don’t know what will happen next, but as equity investors it is always wise to be psychologically prepared for big drawdowns. “Markets go up and down, but what matters” is whether you remain patient during a crash or lose your nerve by panic selling and crystallising losses.