The spectacular success of Alibaba is a massive warning to investors

Alibaba stock flotation © Getty Images
US stocks are over-valued

The Alibaba initial public offering (IPO) was a big success.

Shares in the Chinese internet giant soared 38% on their first day of trading. The company is now valued at $231bn in total. That’s a higher valuation than Amazon and eBay combined.

Such a big first-day rise was great news for Yahoo shareholders – Yahoo owns a 16% stake in Alibaba.

But for everyone else, the Alibaba IPO should be a worry.

It’s further evidence that US shares are over-valued. A market can’t stay over-valued forever. Sooner or later, the US stock market, at the very least, will plateau – or more likely, start to fall…

Why Alibaba worries me

I wrote about Alibaba two weeks ago. The expected valuation of $155bn undervalued Alibaba ‘a little’, I reckoned.

However, the actual IPO price was higher than that. After the first day’s trading, the company’s market value is now $231bn. That puts Alibaba on a price/earnings ratio of 61. That seems high, regardless of the company’s growth potential. (Especially when you remember the concerns about governance and ownership that I discussed in my last article on the company.)

But, in truth, even if Alibaba had listed at $155bn and had risen by a more modest 5% on Friday, I would still be worried about the US market. You see, floating such a large company is only really practical when the market is bullish – otherwise the risk of failure is too high. So the very fact that Alibaba even chose to float now was a sign the market is somewhat exuberant.

Add on a 38% first-day rise, and the Alibaba IPO is giving us a very clear pointer that US share prices are too high.

Alibaba isn’t the only reason to worry. The much talked-about ‘taper’ is almost over. In other words, the US Federal Reserve is expected to buy its last tranche of bonds and other securities in October. Barring any further disaster, this should be the end of quantitative easing (QE – money printing) in the US.

To be fair, the stock market has carried on rising this year, even although the Fed has been gradually cutting its bond purchases. But the end of QE means less money floating around financial markets, and that can’t be a positive for share prices.

Remember also that a rise in US interest rates seems likely within the next six months. That could crimp US growth and make bonds appear more attractive than equities.

Alibaba isn’t the only sign of over-exuberance

Aggressive lending to private equity is another sign of over-exuberance. James McIntosh summed up the situation very well in Saturday’s FT: “Leveraged loans to private equity are not just flashing red but have a wailing siren and a man walking in front waving a flag. The loans are even bothering the see-no-evil officials at the Federal Reserve, who have been trying to persuade banks that excessively leveraged loans are risky.”

This is important because private equity firms normally help to drive share prices higher during a market cycle. These firms borrow large sums of money to buy companies and then encumber the companies they’ve bought with the resulting debts.

McIntosh points out that a third of US leveraged loans are valuing the underlying investments at more than six times Ebitda (earnings before interest, tax, depreciation and amortisation). That’s almost as high a level as we saw back in 2007 at the last market peak.

I’ve left the most important point until last. On a valuation basis, the US looks expensive. At MoneyWeek, we particularly like the Cape measure which stands for cyclically adjusted price/earnings ratio. We like the Cape ratio because it helps you to value a company, or a market, without being distracted by the inevitable movements of the market cycle.

Now the worrying thing is that the US Cape is currently 26, using figures from Mebane Faber’s Ideasfarm website. That’s up from a Cape ratio of 22 in 2013, and is higher than all of the other major markets – the UK is on 14, for example. That screams overvaluation to me.

So what should you do? I’ll be clear – I’m not going to sell all my US investments. I’m a long-term investor, and I know that the US market will probably rise over the next 20 years. I’m also confident that the individual US shares I own have the potential to do well from here – in particular, Amazon and Google.

But I don’t think now is a good time to invest in the overall US market via an exchange-traded fund (ETF) or an index tracker fund. I’m pretty sure there will be better opportunities to buy before too long.

• This article is taken from our free daily investment email, Money Morning. Sign up to Money Morning here.

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