A year ago, few would have predicted the US stock market to deliver the returns it has. The fact that the rally came on the back of the election of Donald Trump as US president only makes the performance of the S&P 500 more remarkable.
Even though Trump’s promises of tax reform have been watered down, and his ambition to revitalise America’s infrastructure has ostensibly been dropped entirely, US equity fund managers keep counting on the US president’s deal-making abilities.
“We would put the odds slightly over 50% that Congress is successful in passing tax reforms bringing corporate tax rates to 20%,” said Nadia Grant, Head of US equities at Columbia Threadneedle Investments.
This would, obviously, boost earnings of many companies. Particularly those stocks that rallied most during the initial ‘Trump rally’ last year on hopes that Trump would act quickly to legislate tax cuts (which he didn’t), such as domestically focused banks, industrials, material stocks and smaller companies that tend to pay higher tax rates, would benefit.
Kurt Feuerman, AB Select US Equity Portfolio Manager at AllianceBernstein, concedes the US equity market is trading “toward the very high end of its historical range.”
Yet he also pins his hopes on Trump, noting that “bank stocks are statistically cheap relative to the [expensive] market.”
“The financial sector is first in line for deregulation. And changes to the post-crisis banking rules proposed by the Republican administration could result in a 20% pre-tax profit increase for some of the largest US banks, according to Bloomberg,” says Feuerman.
Expensive, ‘no matter how you cut it’
Needless to say it is risky to base your investment case on things you hope will be hammered out in Washington, under the leadership of a president whose unreliability has become proverbial over the past year. But fund managers have little choice: US equities are expensive compared to other equity markets, and the prospect of tax cuts and deregulation is necessary to make them look attractive.
American stocks are pricy compared to their peers elsewhere, and it’s often argued that’s because of the different make-up of the US stock market, where ‘expensive’ sectors such as information technology and health care have a much bigger presence than in Europe or Japan.
However, the US asset manager GMO has calculated, even if once corrects for this, US equities are materially overvalued compared to other developed market equities. When adjusted for the high exposure to growth and low exposure to cyclical sectors, US equities trade at a cyclically adjusted P/E-ratio (CAPE) of 26.1, compared to a CAPE of 20.7 for the MSCI EAFE (developed equity markets outside the US and Canada).
“The S&P 500’s premium, even after adjusting for sector differences, to the MSCI EAFE index is easily explained by looking at the relative valuation levels of the two markets,” according to GMO. “In 8 of 10 cases, MSCI EAFE sectors are trading at modest to significant discounts to the S&P 500.”
This all leads GMO to a clear verdict: “No matter how you cut it, the S&P 500 is expensive.”