US stock indices continue to set new all-time highs....
Lukas Daalder, Chief Investment Officer of Robeco Investment Solutions
Growing dislocation emerges with underlying earnings
Momentum strategy leads to our overweight in equities
Stocks have continued to set new all-time highs, with S&P 500 share prices increasing their gap with underlying corporate earnings and other equity markets, says Daalder, Chief Investment Officer of Robeco Investment Solutions.
However, the rally may not end unless there is some sort of crash-inducing event – and there is an irony in that if such a ‘correction’ occurs, the safest place to be would be in the US market, he says. Daalder’s multi-asset fund is subsequently overweight equities, with a precautionary stop-loss in place.
“We are certainly not the first to use the quote of Darth Vader and probably not the last either, but ‘the force is strong in this one’ seems to be a pretty appropriate characterization of the current rally in stocks,” says Daalder.
“Despite all the obstacles thrown in its path, at the end of each month we find that none of them have managed to derail the rally. September, the most volatile of months? Ignored.
The lack of progress on Brexit talks? Who cares. North Korea, the land of little rocket man? A buying opportunity. The weak political leadership seen in the US? A non-issue.”
“The US market has been more than willing to ignore risks and look for reasons to move higher. Momentum is strong, but this has led to an increased worry amongst investors: the US market has become expensive.”
Three ways to value markets
The priceyness of the market can be seen in three ways. The first is by looking at the Cyclically Adjusted Price to Earnings (CAPE) measure, which compares the 10-year trailing real earnings average relative to the price of the S&P 500. The CAPE reading famously peaked just prior to the dot.com speculative bubble, as well as just before the stock market crash which marked the beginning of the Great Depression of the 1930s. “With a reading of 30.7 times earnings at the end of September, US stocks are now well within the 5% richest bracket on record,” says Daalder.
“Another way to show that the S&P 500 has been pricing in a lot of good news – in excess of real economic growth – is by comparing the rise of the S&P 500 with reported earnings. Over the past six years, reported earnings per share have risen by 22%, during which time the S&P 500 has risen five times as much (122%). So there is no denying that during the past years the S&P 500 has structurally outpaced the underlying economy.”
The increasing gap between share prices and underlying earnings. Source: Robeco & Bloomberg
A less orthodox but interesting method developed by Bank of America Merrill Lynch looks at how many hours the average US citizen needs to work to be able to buy one ‘unit’ in the S&P 500. Whereas it took 40 hours at the depth of the 2009 sell-off, it has now almost tripled to 113 hours, the highest level on record.
“Even during the height of the dot.com bubble it didn’t take such a long time to earn the level of the S&P 500,” says Daalder. “Although this may not be a proper valuation tool, it does flag the rising divergence we have seen between labor and capital in recent years. The conclusion is simple: US stocks are expensive.”
“But here is the catch: if there were to be a correction in stock markets, you are probably better off owning US stocks, since they typically lose less than other regions in case of a selloff. Even during events that would normally impact the US more than Europe, such as 9/11 and the sub-prime crisis, European stocks declined by more.”
“Therefore, in case of a general sell-off of stocks, you are probably better off owning US stocks rather than European stocks. This line of thinking results in a strange outcome: US stocks are expensive and may be due for a correction, but if this correction takes place, the US is the best place in which to be invested!”
Reasons to be worried
Daalder says the big question for investors now is whether the overvaluation of US stock markets will become the main concern in the market anytime soon. “Looking at the market, the answer appears to be a pretty clear ‘no’,” he says. “This may be the most unloved rally in history, but that has not stopped it from continuing to this day. Its valuation may be too high, but that in itself is never a good timing argument to sell stocks.”
“The fact that negative news with respect to North Korea has only led to a temporary decline is a clear sign that momentum is strong, and that dips are mainly seen as buying opportunities for now. Valuation in itself is seldom a reason for stocks to correct: you typically need a shock of some sort to trigger a correction.”
Current asset allocation
This thinking is reflected in the asset allocation of Robeco Investment Solutions. “The best way to proceed in this kind of a market is to be overweight stocks, but use a tight stop loss in case the eventual correction is triggered,” says Daalder.
“Having been neutral on equities during 2017, we are certainly not eager or happy to make this move, but sometimes you need to leave fundamental reasons aside and just opt for a more momentum-driven approach.”
“On balance we have reduced our positioning in high yield bonds to underweight because spreads have dropped too low, plus there is a bigger liquidity risk, while we have also increased our underweight to government bonds, to the benefit of equities. This is a momentum-driven trade, and the presence of a stop-loss may mean that this position can be unwound at short notice.”