While investors are intensely focused on the outlook for US economic growth and inflation, the strong revival from the US equity market over the past 12 months - alongside rising long-term interest rates - has thrown the spotlight back on global equity valuations. Gaining particular attention is the question as to whether the US equity market (almost 70% of the global equity universe) is overvalued.
US stock-market Has Defied the Valuation Bears
Concerns around US equity valuation have been expressed by many market commentators for some years now. While US market performance has been volatile, performance has been much stronger than most (particularly the valuation bears) expected over the past 5 - 10 years, with the US delivering well ahead of both Australia and the rest of the world.
Part of this story has been a persistent valuation re-rating, which in turn has led to the valuation of the US market being questioned. However, far and away the dominant driver of US outperformance has been its superior earnings growth over the past 5 - 10 years. The US was helped by a generous Trump corporate tax cut at the beginning of 2018 (we estimate this has improved 10-year per annum earnings growth by just under 1% per annum). However, earnings growth has been just as strong over the past 5 years, which effectively excludes any material earnings uplift from the tax cut.
| US | EAFE | Australia | |
| (rest of world) | |||
| 5 years EPS growth pa | 7.3% | 2.7% | 4.1% |
| 10 years EPS growth pa | 7.6% | 1.9% | 3.1% |
Source: Refinitiv, Wilsons.
Our analysis of long-term earnings growth delivery suggests the re-rating in US equities, when assessed at current valuation levels, is indeed justified. This assumes such earnings performance can be replicated over the medium term, with structural bears continuing to argue for a fade in US profitability. However, the technology related structural drivers of the US earnings growth premium continue to look positive to us.
This does not guarantee the US equity market will do well over the coming year. Growth, inflation and the policy cycle are likely to hold the key to the shorter-term outlook. But the structural picture does, in our view, suggest the medium- to long-term outlook for US equities (i.e., the next 3-5 years) is significantly better than is often asserted by the valuation bears.
US Valuation Concerns: A Concise Summary
Concerns around US valuation typically focus on one or more of the following valuation concerns.
The US appears expensive versus its own longer-term valuation history (i.e., the past 20 - 30 years).
The US is “expensive” (trades at a large premium) relative to the rest of the world (i.e., the EAFE index comprising UK, Europe, Japan and Australia).
The US is expensive on a “normalised profitability” basis. This thesis is in large part at the heart of the Shiller PE or “CAPE” overvaluation argument.
More recently, concerns have resurfaced that the US is “expensive versus bonds”.
US Equities: Feel the Quality
For some years, we have been on the more sanguine side of the US valuation argument. We view the US as broadly fair value at current levels. The heart of our thesis is relatively simple.
The US has a much higher quality universe of “growth” companies (at least in a size-weighted sense), which has resulted in superior earnings growth that justifies its premium valuation.
We expect this inherent tilt to quality global franchises will continue to drive superior earnings per share (EPS) growth over the medium to long term. Once again, this does not guarantee good performance every year, but it does suggest to us that 3- to 5-year return prospects for the US are still good.
The US Has Over-delivered over the Long Term
While we believe there is elevated uncertainty over the 12-month outlook for US equities as the US and global economies slow, what is clear is that the US has delivered over the long term from an earnings growth perspective.
Looking at 5- and 10-year earnings growth highlights the large earnings growth premium the US market has delivered (see figures 2 and 3). Based on the entrenched position of US mega caps and their exposure to many attractive long themes - for example, artificial intelligence (AI) and cloud computing - we continue to expect the US will outgrow the rest of the developed world, including Australia.
Valuations “Cheaper” Outside the US, but Earnings Growth a Concern
Valuations in EAFE (rest of world) appear fair to “possibly” cheap while Australian valuations look fair, in our view. We do have concerns with respect to the earnings cycle over the next 12 months, particularly in EAFE where the largest component, UK/Europe, looks cyclically vulnerable. Longer term, the “world ex US” does possess the potential for a re-rating given the low current price-to-earnings ratio (PE) and its discount to the long-term average level. However, we would caution that such a re-rating is not justified on the basis of the 5- to 10-year earnings track record. In Australia’s case, the current valuation of the market in aggregate seems fair when assessed against historical earnings growth.
Equities versus Bonds: Are US Stocks Now Expensive versus Bonds?
The argument that US equities are expensive relative to US bonds has emerged again in recent months, as bond yields have moved up rapidly to levels not seen for many years, while equity multiples have compressed only marginally.
At current bond yields, there does appear to be a case that bonds are more attractive than equities, at least cyclically. Indeed, we increased our weighting to bonds versus equities just last week.
This is more of a tactical (12-month) position. US equities would be vulnerable if bonds pushed higher, or indeed even if they held current levels, but we expect bond yields to ease over the coming year as growth and inflation both slow. This should at least support current equity valuations.
US Equities Deserve Some Respect
In summary, we see the common refrain that the US market is overvalued as overly simplistic. The US has over-delivered in terms of earnings growth for some time now. We continue to see its medium- to long-term earnings prospects as bright, with AI and related technology themes a key driver.
The US economy has its share of challenges, both cyclical (slower growth as monetary policy bites) and structural (chronic fiscal deficit spending). However, the quality of US corporates (most notably the US mega caps) cautions against a negative structural view on US shares.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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