US stocks look very overvalued – no matter what happens to interest rates

With all the kerfuffle about the taper' in the summer, you might have thought that US easy money policy was set to wind down.

However, comments this week from the Federal Reserve's current boss Ben Bernanke, and its likely future boss, Janet Yellen, suggest that easy money will continue for much longer.

In other words, ultra-low interest rates aren't going away.

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So time to fill your boots with US stocks then? Not so fast.

The promise of ongoing low rates may be positive for the US stock market in the short-term. But the fact is, US share prices still looked over-valued on many measures.

That overvaluation has to be corrected eventually - regardless of anything that Ben or Janet might say.

The Fed bosses will keep rates low but the market has to correct sometime

quantitative easing (QE)

But current Fed boss Ben Bernanke made it very clear this week that even if QE does tail off, that doesn't mean that interest rates are anywhere near rising. In fact, the benchmark Fed funds rate is likely to stay near zero for "a considerable time after asset purchases end".

Meanwhile, his successor Janet Yellen told a US senator that the Fed funds rate wouldn't necessarily rise even if the 6.5% unemployment threshold' was crossed. (A little like the Bank of England, the Fed had previously suggested it wouldn't raise the Fed funds rate until unemployment fell to 6.5%. The current unemployment rate is 7.3%.)

So it looks like the Fed funds rate will stay near zero until the end of 2014, if not longer. And that will probably provide support for the US stock market's current heady levels. More often than not, low interest rates should mean high share prices.

Trouble is, the US stock market looks rather overvalued.

That's certainly the view in the latest quarterly letter from GMO, a US asset management firm. GMO's founder, Jeremy Grantham, has an impressive record of calling market movements successfully.

He avoided the Japanese property and stock market bubbles in the late 80s, as well as the US internet bubble in the late-90s. More importantly, he's not a stopped clock' in early 2009, he argued it was time to get back into the market and invest, so he pretty much called the bottom too.

GMO uses a model that looks at return on sales and the replacement costs for a company's assets. In its latest letter, Grantham's colleague Ben Inker suggests thatfair value for the US S&P 500 index is just 1,100. That's 40% below its current level.

What's more, the letter predicts that US investors will receive an inflation-adjusted annual return of 1.3% over the next seven years. In other words, their money will fall in value by more than 1% a year in real terms. Not very tempting.

Grantham isn't alone in the gloomy camp. Carl Icahn, the billionaire activist investor, has warned, "this market could easily have a big drop." He believes that much of the recent rise in company profits has been driven by the opportunity to borrow cheaply rather than long-lasting organic growth.

And if that doesn't convince you, look at the Schiller cyclically-adjusted price/earnings ratio (Cape). This compares a company's p/e ratio to its long-run average.

We like the Cape because it filters out short-term statistical noise and sure enough, the Cape ratio suggests that the S&P is overvalued by around 50%.

The US market could keep rising, but don't get sucked in

It's more likely that dovish noises from Bernanke and Yellen will reassure investors and persuade them to keep buying. I wouldn't be surprised if the US market continued to rise in 2014, and possibly beyond. Even Grantham acknowledges that markets may rise a further 20 or 30% over the next two or three years.

But at some point, the S&P's over-valuation will have to end. Either the S&P will tread water for several years until earnings rise sufficiently to justify the market's valuation, or we'll see some serious share price falls.

Now that doesn't mean I'm selling all my US investments. I might sell some, but I'm reasonably confident that most of my US shares will be able to cope with volatile markets. But if the taper gets delayed again, and rates remain at ultra-low levels, I won't get sucked into any fresh euphoria either. That could lead to some serious losses.

Instead, I'd rather invest in markets that are less clearly overvalued. I mentioned in Money Morning on Tuesday that it looks increasingly like now is a good time to invest in China, for example. And we discuss China in more detail in the latest issue of MoneyWeek magazine, out tomorrow. If you're not already a subscriber, subscribe to MoneyWeek magazine.

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