US equity valuations have been too high for too long

US equity valuations have been too high for too long

Valuations of US stocks have reached historical extremes, relative to those of other markets. It is hard to see how this situation can be maintained — but just as difficult to predict when the reckoning will come.Companies listed in America have always commanded a premium, so that much is not new. Our proprietary price/earnings multiple for US equities currently stands at 26, compared with 15 for non-US equities.But the size of the disconnect has grown. The ratio between those two earnings multiples, at 1.7 today, compares with a 20-year average of just 1.2.Much of today’s exuberance has been driven by three big beliefs: that US companies’ quality justifies elevated premiums; that their strong profit margins are sustainable for the indefinite future; and that they will not suffer much in a trade war.Investors would be well advised to remember that current premiums are exceptional, and that those three beliefs all holding true would be exceptional, too.While US equities offer higher returns on equity and returns on invested capital than their counterparts around the globe, that has always been the case. Over the past 20 years, the median ratio of US companies’ return on equity to that of non-US companies has run at 1.4 times.Those figures have not increased in several decades, so why should they be driving up US companies’ valuation premiums today?One possible reason is that in a lower global growth environment, especially one threatened by prospects of disruption from escalating geopolitical rivalries and populist economic policies, growth and stability are more valued by investors. Such stability is particularly valuable when return prospects for high-quality government bonds are paltry. These supports will not last forever.Although profit margins have remained elevated for an unusually long period of time, the tide is beginning to turn. Lower corporate taxes, cheaper costs of borrowing and falling labour expenses have supported US profit margins.It is unlikely we will see further decreases in tax and debt expenses. Most of the key forces keeping a lid on wage costs are also starting to fade. On balance, the evidence suggests we are at or near peak margins, and should be prepared to see them compress over time.The trade war also puts US profit margins at risk by directly threatening the part of the market that has generated most of the expansion — the tech sector and other manufacturers. According to analysis by Empirical Research Partners, manufacturers in the S&P 500 index generate profit margins nine percentage points higher than the rest of the market.Even without added tariffs and restructuring of supply chains, future wage savings from offshoring may be limited. Chinese labour costs, for example, have already increased enough to entice some manufacturers to move production to lower-cost producers such as Vietnam and Bangladesh.There are limits, however, on those companies’ ability to handle the same types of manufacturing done in China without meaningful investment and time to improve. At the same time, politicians and regulators have awakened to the role that increased concentration in US industries has played in limiting workers’ bargaining power, suggesting that the pendulum may be swinging in the other direction.There is room for greater efficiencies. The use of robotics in the US, for example, lags behind Asian countries, meaning there is potential for further adoption to cut costs. However, even as automation reduces costs and improves the margins of individual companies, employee pay could eventually fall enough to limit consumption and ultimately reduce the aggregate profit margins of US companies.Finally, trade tensions could strain profit margins beyond what is priced into the market. While exports are not a particularly large share of US GDP, US corporations are heavily exposed to global supply chains and foreign operations, while China has plenty of tools to manage through a long period of trade conflict. Increased tariffs will result in higher consumer inflation and currency volatility, and if significant and prolonged, supply chains will ultimately shift — rendering some manufacturing and distribution infrastructure obsolete.The key variables, of course, are the degree to which tariffs and other constraints on trade escalate and how long the escalation lasts. Fiscal and monetary policy would normally be able to take the edge off these pressures, but given low policy rates, large central bank balance sheets, and elevated government debt levels across much of the developed world, policymakers have less firepower today than they have had in the past.The US has a heavy dose of high-quality, innovative companies that deserve premium valuations, but it is hard to find strong justification for today’s extraordinary valuations. The crunch may not come until the next recession, particularly as US equities tend to be defensive in times of stress. Given the stage of the economic cycle, investors should be cautious about underweighting US equities right now, but be prepared to act after the next recession hits.The writer is chief investment strategist at Cambridge Associates in Washington, DC


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