US stocks look too expensive: here’s what to buy instead

published 2 August 2013

13-08-02-wall-street — The US market is expensive

The S&P 500 hit a fresh record high yesterday, rising above 1,700 for the first time ever.

The US stock market is going great guns. On the one hand, the US economic data is gradually getting better. On the other, the Fed seems to be taking great pains to reassure investors that it won't stop printing money if it doesn't think they can take it.

So it makes sense to pile into the US market, doesn't it? Well, I'd say no, you shouldn't.

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The US is expensive. Buying stuff when it's expensive usually ends in tears in the long run.

So why risk it when there are cheaper options elsewhere?

Why value investing works we're all too impatient

a few successful value investment funds in the US

A value manager's strategy can be summed up in four words: "buy low, sell high". You find a company. You calculate its fair value' by actually looking at its accounts, rather than worrying about whether it has a good story you can sell to your investors. If it's trading well below where you think it should be, and there's a sufficient margin of safety' to shield you if you're wrong, you buy it.

The idea is that in the longer run, the market catches up with your thinking, and the price goes back up. That's when you cash in.

Value investing is a long-term strategy. You only buy when you see something that fits your criteria. And that sometimes means that you don't buy anything.

That's unpopular in our world of instant gratification. Which is nothing new, by the way - investors have always sought instant gratification. It's just that it used to be harder to trade at quite as hyperactive a pace as we can today.

But you see, that's why value investing consistently works. There's a general view that successful investment strategies should stop working over time, as everyone recognises that they work, and starts copying them.

This might be true of short-term trading strategies. But the nice thing about value investing is that it takes advantage of our psychological quirks. You can't stop human beings from being impatient, and from running in crowds. So assets will always end up being mispriced at some point. You just have to be patient.

Anyway getting back to the piece on value managers. "The average diversified US stocks fund has less than 5% in cash" right now, says Carla Fried on Bloomberg. That's because they're bullish and want to be fully invested.

But some very successful value funds have much bigger cash holdings. Big funds at Weitz Partners, for example, have about 30% of their money in cash. Both of the funds have soundly beaten the return on the S&P 500 over the past 15 years, so they are clearly doing something right. Why so much money in cash right now?

It's simply that stocks aren't cheap enough. "There's no big macroeconomic prediction fuelling the move of these value managers into cash. Just some simple investing discipline."

The Weitz managers, for example, like to buy stocks that sell for less than half of what they estimate to be fair value'. Right now, they say, the stocks in their portfolio are on average trading "in the high 80 percentage range, which is probably close to an all-time high for us".

In other words, they simply aren't finding anything cheap out there, and the stocks they do hold have gone up sharply. That's why they're taking profits and building up their cash stash.

The skyscraper curse strikes again

cyclically-adjusted price/earnings (p/e) ratio

That doesn't mean the market can't get more expensive. It doesn't mean that prices won't go higher from here. We're a long way off the record high in cyclically-adjusted p/e terms, which was above 40 (during the tech bubble).

But history suggests strongly that you make the best returns by buying stuff when it's cheap, and selling when it's expensive. So if you're a longer-term investor, rather than a momentum trader, you'd be looking to take profits in the US and reinvest them elsewhere.

So where should you put that money instead?

You know that we like Japan James Ferguson will be looking at what comes next for that market in next week's issue of MoneyWeek magazine (if you're not already a subscriber, subscribe to MoneyWeek magazine). And cheap eurozone markets have held up nicely too.

Another area we're starting to get interested in again is commodities. There are lots of reasons to be concerned about commodities China's slowdown being the main one. But I'm ever more convinced that the bad news for China is being priced in.

One of the top stories on Bloomberg earlier today was about China's Shanghai Tower hitting its highest point. The Shanghai Tower will be the country's tallest building when it is finished in 2015. The implication is that China will fall victim to the skyscraper curse' a long-running big picture' indicator that shows that the construction of big vanity projects tends to coincide with economic slumps.

I happen to think the skyscraper curse is worth keeping an eye on it's a factor we've looked at several times in the past. But when everyone knows about it, you have to think that it's probably in the price.

For now, I'd say the best way to play any shift in sentiment towards China, is through the mining sector. We looked at some ways to play the mining sector in last week's issue of MoneyWeek.

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.