Leaving the US equity party early may mean foregoing big gains, according to Christopher O’Dea
Investors often talk about a Goldilocks market. But pension fund managers may want to turn to Cinderella for guidance on how to navigate today’s US equity market. Like the princess for an evening, they need to know when to leave the party in time to avoid adverse events – but not before securing their fortune.
With US equities at lofty valuations and volatility on the rise, talk of bubbles is in the air and investors are heading for the door. From January to April 2015 investors pulled $18bn (€16bn) from US equity ETFs, the largest such retreat since 2009, reflecting allocation cuts by numerous asset managers seeking to redeploy capital to sectors offering better prospects for price gains in the coming year.
Knowing when to underweight equity allocations to the world’s biggest developed market is a high-stakes decision. But investors could leave money on the table by bailing out of US equities too soon. Even some large investment managers that have been trimming US equity allocations say valuation itself is not an optimal timing tool; economic growth could end up being strong enough for revenue gains to keep pace with stock price gains, thereby keeping valuation metrics in line.
And with valuations at low levels in some industries, sector selection arguably matters more than the overall level of market value.
What’s at stake? Quite a lot, according to Goldman Sachs Investment Management (GSIM), the bank’s umbrella entity covering private banking and institutional asset management. There is no doubt US equities are trading at lofty valuations. A recent strategy note observes that US equities are expensive and have been for some time: “We have been in the ninth decile of US equity valuations for 18 months and may well remain here for the rest of the year.”
Equities entered the ninth decile of valuation in November 2013, based on GSIM’s valuation metric, which is an average of five valuation measures including the Shiller cyclically adjusted price-to-earnings ratio. From November 2013 to May 2015 the S&P 500 returned 23%, although valuations have not moved into the tenth decile as earnings have expanded at a similar rate to prices. While prices have increased by 5.8% annualised in the past 10 years, according to GSIM, operating earnings have kept up with annualised growth of 5.1%.
A look at US equity performance in the tech bull market of the late 1990s illustrates what investors might leave on the table if they leave the party early. First, GSIM’s valuation indicator entered the ninth decile in November of 1995. The S&P 500 returned another 44% before reaching the tenth decile – and went on to return an additional 170% before peaking in August 2000. The firm’s indicators also signalled a 95% probability of a bubble in July 1995. But the S&P 500 rallied for another 61 months before peaking – adding 194 total return percentage points.
Investors must take account of the opportunity cost of avoiding inevitable declines in market values. GSIM notes: “Even after US equities lost almost half their value when the technology bubble burst they bottomed at a level 63% higher from where they entered bubble territory in July 1995.” An investor who acted on the initial underweight signal would have avoided the plunge, but would not have had an opportunity to re-enter the market at a level lower than the point at which they exited.
So although US equities are well priced, it is vital that investors take the broader economic environment into account, as well as the attractiveness of other equity markets. “Through the lens of valuation, relative to history, the US stock market is expensive,” notes Jack Ablin, chief investment officer for $68bn (€60.5bn) in assets under management at BMO Private Bank.
At a glance
• Knowing when to underweight US equity allocations is a key decision.
• Despite high valuations for US equities it is important investors consider the valuations of other markets and the broader economic environment.
• Strong earnings growth is required if equity markets are to perform well.
Ablin began reducing the allocation to US equities in the second half of 2014, and continued the shift early this year. The primary driver of the decision for BMO was the expansion of the S&P 500 price-to-sales ratio to 27% above its 20-year median, Ablin says. He now neutral-weights US equities, with an overweight in large-caps and a “massive underweight” in small-caps. Assets have been redeployed into an overweight position in non-US stocks, with international small-caps also underweight.
Although BMO has reduced US equity exposure, Ablin says that valuation by itself is not a great timing tool. “Had we looked only at valuation we would have sold out in the fourth quarter of 2013,” he notes. Valuation, he says, “is a great environmental tool”, providing a basis to assess the many factors affecting the relative attractiveness of equity markets at any given time.
BMO’s cutback in US small-caps, for instance, came after the price-to-sales ratio for US small-caps rose to 37% above its median. That valuation uptick resulted from the strong price performance in smaller caps as investors looked to smaller companies with lower ex-US sales as a shield against the impact of the rising dollar on large US companies exposed to exchange-rate losses on foreign sales.
Ultimately, earnings determine whether a given equity valuation is expensive or cheap, and that conclusion can only be made at the stock level, says John C Thompson, CEO and CIO of Chicago-based Vilas Capital Management, a value manager. “I make the analogy to real estate,” he says. “Determining valuation depends on what part of the market you’re talking about.”
Thompson estimates that about 10% of US stocks are currently cheap, and relies primarily on book value multiples to identify long and short positions. Overall, stocks appear to have room to run – the book value multiple of the S&P 500 is currently 2.9 times, and has been as low as 1.9 times in 2009 and as high as 5.0 times in 1999, he says. “This tends to be the best predictor of future value,” he adds, because current market valuation is “some function of liquidation value”.
Whichever metric investors use to assess the environment and a company’s prospects, it seems clear that investors are taking a similarly hard-edged look at valuations and reining in US equity return expectations. An October 2014 report by Pension Consulting Alliance summarising the return projections of eight investment consultants and five asset managers for a portfolio of 70% equities found a median projected return of just 5.9% over the next 10 years.
That looks like a step in the right direction. Goldman Sachs Asset Management, the institutional subdivision of Goldman Sachs Investment Management, has found that that since 1945, when stocks are valued in the ninth decile, they produced a 5% price gain over the next five years. “Pricey equity valuations,” says GSAM, “historically have led to mid single-digit returns.”