There were signs that US stocks were overvalued even before the recent correction, according to GAM multi-asset manager Charles Hepworth, who has already begun allocating outside of the world’s largest economy.
The most recent sell-off in the US has served as a reminder for investors about how much longer the bull run has left to run.
Since the start of the month, the S&P 500 index has fallen by 5.55 per cent – in US dollar terms – and year-to-date the index has returned just 3.98 per cent compared with 2017’s 21.1 per cent gain.
Performance of index YTD
Source: FE Analytics
Hepworth, co-manager on the £565.1m GAM Star Balanced fund alongside James McDaid, said at the start of the year many investors believed that the US expansion “was still delivering” but moving to a later phase of the cycle.
The tax cuts enacted by US president Donald Trump at the end of 2014 served as a shot of adrenaline to the US financial system as markets powered ahead of their global peers following the synchronous global growth of 2017.
“For much of the period since August 2016, global markets have largely moved in tandem,” said the GAM manager. “However, in 2018 they have become more negatively correlated: US markets have continued to rise higher, while much of the rest of the world has dwelt in negative territory.
“In our view, this scenario is strange given the underlying dynamics of the US market.”
The most recent correction – which follows a previous sell-off earlier in the year – has come after comments by Federal Reserve chair Jerome Powell raised concerns that the central bank could hike rates more aggressively.
However, Hepworth said the correction was little surprise given that there were a number of key issues making valuations seem stretched in the US.
“Firstly, the Citi Economic Surprise index appears to have completely disconnected from US equity trends; signs of worsening data have been ignored and the equity market has marched on regardless,” he explained. “In our view, this trend is not sustainable.”
Indeed, Hepworth – who also co-manages the GAM Star Cautious, GAM Star Defensive, GAM Star Dynamic Growth and GAM Star Growth – said the US CAPE (cyclically-adjusted price-to-earnings) index was currently in ‘warning’ territory.
“The US CAPE index, which shows the P/E [price-to-earnings] ratio based on inflationary-adjusted earnings from the previous 10 years, is currently over the ‘warning’ level of 25x for only the fourth time since the start of last century, indicating the market is overpriced,” he said.
US CAPE priced for peak optimism
Source: GAM
“The reverse CAPE index, which compares earnings yields with the risk-free rates from Treasury bonds, suggests we are now in a situation where the rate on Treasuries is more attractive – another sign that US equities are not cheap.”
Another measure worth considering, said Hepworth was the EBITDA (earnings before interest, tax, depreciation and amortisation) multiple which is currently at a peak of 12x.
Indeed, rising import costs from tariffs imposed by Trump could slow overall demand for US goods while a strong dollar eats away at foreign sales, said the manager.
“These all point to US earnings potential having peaked, which we believe has already been priced into the market,” he added.
One further sign from markets that equity valuations have peaked is the level of US equity buybacks, which Hepworth said are at record levels.
Additionally the manager noted that there has been a significant divergence between US household net worth and GDP pitting the US in position where “almost everything is overvalued in our view”.
“We find these big disconnects worrying because the resulting downdraught can be even more painful,” he explained. “Estimates of this overvaluation are in the region of $30trn. Again this is not sustainable.”
Continuing on the broader economy, Hepworth said a widening budget deficit in the US is also a major challenge likely to be amplified by Trump’s tax cuts as revenue fail to plug the gap.
“Deficit increases of the current magnitude typically only occur in recessionary periods, therefore given the US is still in a period of growth this scale of debt is unnerving,” the GAM manager explained.
“Moreover, it has not proven to be a good time to buy stocks when the rate of unemployment is at a cyclical low, as it is now. It could also be a bad time to buy stocks when the yield curve is flat and on the verge of inverting.”
Further cause for concern is given by upcoming mid-term elections. Hepworth said its most likely scenario – in which Trump’s Republicans were to lose the House of Representative but retain the Senate – would be negative for the stock market.
Such a result would increase the potential for policy gridlock and potentially slow growth while trade policy – led by Trump – would remain aggressive.
“In our view, the market reaction would be muted but both the US dollar and equities would feel some selling pressure,” the GAM manager said. “Bond market stress would probably be contained as additional fiscal stimulus would be less likely.”
Hepworth said he has not been surprised by the extent of the most recent sell-off, adding that there is potential for it to worsen.
“We believe additional catalysts which could trigger further selling include US inflation rising significantly; the Fed making a policy error and tightening too quickly; and bond rates moving rapidly higher by pricing in full employment and imported tariff inflation,” he explained.
“In our view there have been far better entry points into the US market than at present and there is better value to be found elsewhere.”
Hepworth has managed the GAM Star Balanced fund since October 2012 – being appointed to the fund shortly after launch – and seeks to deliver an attractive return while also limiting capital loss through investment in a range of funds targeting different asset classes.
Performance of fund vs sector under Hepworth
Source: FE Analytics
During Hepworth’s time it has returned 42.55 per cent compared with a gain of 50.19 per cent for the average IA Mixed Investment 40-85% Shares fund.
The fund has an ongoing charges figure (OCF) of 1.51 per cent.