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Should investors steer clear of American equities?

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Although stocks on Wall Street touched record highs in August, the world's most important equity market appears to have a mounting set of challenges and if they can't be overcome it will have clear negative implications for the local market and Australian investors.

From a longer-term perspective, it's worth appreciating that America's equity bull market is into its eighth year since the financial crisis, meaning it's now the second longest on record - and only surpassed by the stellar 13-year bull period from 1987 to 2000.

That last bull market ended with a tech inspired bubble in valuations, which was partly pricked by the start of Federal Reserve policy tightening over 1999 and 2000. Thankfully, US stock valuations are not at the lofty levels they were 16 years ago, but outright valuations are still rich nonetheless and the Fed is moving into a tightening mode once again.

Indeed, the S&P 500's price to forward earnings ratio is hovering around 17, or close to the levels that stopped the market's advance in early 2015. Outside of the dotcom bubble period, US equities have usually struggled to push much beyond current PE valuations.

That said, although overall US corporate earnings have flattened out the past year - not helped by the collapse in America's shale oil boom - lower bond yields due to low global inflation and aggressive central bank policies across the globe have helped support valuations. If (and it's a big if), bond yields were able to stay very low, stocks valuations don't look that richly priced and valuations might rise further.

Looking forward therefore, a key question is the extent to which bonds yields are now set to rise due to Fed policy tightening.

Given low US unemployment and some upside pressures to inflation, the Fed seems likely to raise rates in December, and should likely raise rates at least twice more in 2017. At the same time, central banks in Europe and Japan also appear to be re-thinking their experiment with negative interest rates, as it seems to be more hurting than helping their financial sector.

All up, I'd be counting on a moderate rise in global bond yields of at least around one percentage point over the coming year. That should be enough to stop equity valuations rising further, and might force outright valuations back down somewhat.

Meanwhile, US corporate earnings seem equally challenged. Although the drag on earnings from weakness in the oil sector is bottoming out, overall profit margins are still high but falling. With a tightening labour market, only modest economic growth, and a firming US dollar, it's hard to see US corporate earnings staging a feisty comeback anytime soon.

Overall, this suggests a fairly sluggish equity performance and some risk of a deeper cleansing market correction to restore valuations to more alluring levels. Under such a scenario, Australian equities will also likely struggle to make strong gains, with the 6000 level on the S&P/ASX 200 Index remaining ever elusive.

David Bassanese is chief economist at BetaShares

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Comments
Chris
October 19, 2016 1.47pm

I'm a DIY investor and currently, the US S+P500 index feels very overvalued, especially on traditional metrics like the P/E, P/B, the "Zone System", Fear vs Greed and CAPE ratios...I'd love to invest more via the ETFs that I use (buy and hold since 2008) but not at these prices.

I'm going to wait until more normal and realistic valuations present themselves

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