So far in 2018, U.S. stocks have delivered gains far in excess of leading markets abroad, and the performance gap widened in the third quarter. In the process, the valuations of U.S. stocks have become much richer than those of key overseas indexes, trading at their highest premiums since 2009, per research by Bank of America Merrill Lynch (BofAML), as cited by The Wall Street Journal. Jack Ablin, chief investment officer (CIO) of Cresset Wealth Advisor, told the Journal: “It’s hard to imagine that the divergence in valuation is sustainable. Good things are happening in the emerging world, but global investors are attracted to the U.S. at the moment."
U.S. stocks may be too rich. They trade at a 12% premium to an MSCI index of 46 developed and developing markets, according to BofAML.
Relevance for Investors
A few months ago, U.S. stocks seemed the safest bet for equity investors. Economic growth appeared to be waning in the eurozone and a rising dollar was making various emerging markets less attractive for investors, per the WSJ. Since then, the dollar has weakened and trade conflict between the U.S. and China has intensified. Comparisons of year-to-date (YTD) performance for major worldwide stock indexes are in the table below.
U.S. Stocks Are Crushing Their Rivals
|S&P 500 Index (SPX)||U.S.||9.4%|
|Nikkei 225 Stock Index||Japan||5.9%|
Source: Yahoo Finance; computed as of 4:00 PM New York time Oct. 3.
Julian Emanuel, chief equity and derivatives strategist at trading, investment banking and research firm BTIG, told the WSJ: "If you look at [U.S.] valuations, absolute performance...they are all extremely stretched. We are very sympathetic to the idea that there's going to be a convergence between the U.S. and the rest of the world." The September iteration of the monthly BofAML Global Fund Manager Survey finds that such convergence is likely to be spurred by decelerating U.S. GDP growth, rather than rising growth elsewhere. This is the opinion of 50% of respondents, who include many of the most influential investment managers worldwide.
Nobel Laureate economist Robert Shiller of Yale University, developer of the CAPE stock market valuation methodology, has been warning all year that U.S. stock valuations are very high compared to historic norms, and even exceed levels reached before the 1929 Stock Market Crash. While he is not predicting an imminent market crash, he is confident that U.S. stocks will deliver paltry returns for a number of years ahead. On the other hand, Shiller's critics, such as Rob Arnott of Research Associates, offer reasons why CAPE should be on a secular uptrend, such as the maturation of the U.S. economy and more stringent financial reporting standards. (For more, see also: The Stock Market Is About to Turn Ugly for Investors.)
Jim Paulsen, chief investment strategist at The Leuthold Group, finds that defensive stocks have been leading the U.S. stock market recently, and his analysis of history finds this to be a very bearish indicator. Morgan Stanley finds that, so far, 2018 has been the worst year since 2008 across many asset classes, with the notable exception of U.S. stocks. However, they believe that rising interest rates will make matters worse. (For more, see also: Why Stock Market's 'Out of Whack' Leadership Signals Next Crash.)
A key to the sustainability of high U.S. stock valuations is U.S. economic growth. As long as it can continue to expand at the current torrid pace of 4% or so, that may keep corporate earnings increasing at a rate that meets investors' expectations, supporting the valuations. On the other hand, if pessimistic observers such as Oppenheimer are correct, and the U.S. economy is peaking, history indicates that a bear market is bound to follow. (For more, see also: The Economy Is Flashing Warning Signs to Investors.)
Interest rates are another big factor. As rates rise, stock valuations are bound to decline, as expected future earnings are discounted at a higher rate, giving them a lower present value. Also, even if high valuations can be maintained, and stock prices either stabilize or continue on an upward trajectory, large pullbacks and corrections should be anticipated along the way.
Lastly, it should be noted that even leading financial firms do not speak with a consistent voice. As just one of several recent examples, while some analysts at Oppenheimer see a recession ahead, others see a bullish indicator in soaring commodities prices. (For more, see also: Why Commodity Prices Indicate New S&P 500 Highs.)