The US equities conundrum: expensive but can’t be ignored

July 4, 2017

US shares look expensive on a range of measures and this does not bode well for holders of S&P 500 index tracker funds, cautions Tilney Bestinvest’s Jason Hollands. 

As American’s once again break for their annual 4 July Independence Day holiday, it is perhaps worth UK based investors also pausing to reflect on the significance of the US both as the world’s largest economy and pre-eminent capital market.

As measured by market capitalisation, US equities account for a staggering 53 per cent of global equity markets (based on the MSCI ACWI Index) and the US is home to many world leading companies whose products and services many of will come into daily contact with such as Apple, Microsoft, Facebook, Johnson & Johnson and Coca-Cola.

Above all, a hallmark of the US economy is its reputation for innovation and this is evident in its undisputed dominance in high growth industries such as technology and biotechnology. This is clearly reflected in the make-up of its stock markets compared to those on this side of the Atlantic. Whereas IT companies make up a pitiful 0.9 per cent of the UK’s FTSE All Share Index and just 4.7 per cent of the FTSE European ex UK Index, technology companies account for a meaty 22.3 per cent of the S&P 500. Long-term growth investors therefore ignore US equities at their peril.

UK investors are underweight the US

Historically most UK investors have been vastly underweight the US, anchored to the UK stock market with its high weightings to the oil and gas sector and financials. According to figures from the Investment Association, the combined assets under management in the North American and Norther American Smaller Companies fund sectors represent just 8.7 per cent of total equity fund assets under management. Even assuming that half of the assets in global funds are also invested in US equities, this brings the US share of total Investment Association equity funds under management to around 17.7 per cent which compares to 42 per cent in the various UK equity fund sectors.

Yet despite the global significance of many US companies, unlike the UK stock market, which has a relatively low level of correlation to the UK domestic economy (over 70 per cent of FTSE 100 company earnings made outside of the UK), the S&P 500 Index is much more intertwined with the state of the US economy. Goldman Sachs estimates that 69 per cent of the aggregate revenues of S&P 500 companies are generated domestically and, in turn, some 69 per cent of US GDP is driven by consumer spending.

The health of the US economy and its consumers therefore really does matter, as this has a direct impact on the US equity market from which other developed equity markets ultimately take their lead.

US stock market valuations look stretched

At the moment one of the conundrums facing UK investors when considering investment in the US equity market is the valuation of US shares, which look stretching on a range of measures. The current forward price/earnings multiple of the S&P 500 Index is 18.1x earnings, the highest level since the dot com bubble, whereas on a cyclically adjusted p/e basis (which measures valuations against a longer term trend) the index is trading at almost 30x earnings, well above the long-term average of 16.8x.

While the US economy is in reasonable shape and US companies have had a strong reporting season, looking ahead a key concern is the tightening US labour market. Unemployment in the US, at 4.67 per cent, is well below the normal level of full-employment, so further tightening will push wages and inflation higher. The Federal Reserve will need to walk a careful path of normalising interest rates and exiting QE so that it can rebuild its policy toolkit to fight future downturns, without choking off growth by acting too aggressively in the process.

Expect lower future returns – in theory

In this environment of policy transition and high share valuations, a period of more muted returns might be expected than the stellar ones investors have enjoyed in recent years. With many UK investors choosing to hold their US exposure through US index trackers which have served them so well during the bull-run of recent years, it may make sense to reappraise received wisdom of investing solely through low cost S&P 500 Index trackers which would be particularly vulnerable in the event of sell-off.

That might involve taking a more selective approach and investing with one of the few active funds to have beaten the market, such as Loomis Sayles US Equity Leaders, but for many the abysmally low success rate of US active fund managers means they will be deeply reluctant to put their faith in higher cost funds.

One way to square this circle might be to consider use of factor funds which passively hold a basket of US shares but weight these on criteria other than market-capitalisation. An example is the Powershares FTSE RAFI US 1000 UCITS ETF  which provides exposure to the 1,000 largest US companies weighted on a basket of four fundamental factors: revenues, cash flows, dividends and net assets their balance sheets. It is an approach which provides diversification at a lower cost than active management and enables continued exposure to the key US stock market but should prove relatively defensive by tilting towards the more financially robust companies than a traditional tracker fund.   

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