Snap up cheap British stocks

American stocks are looking very expensive, but that doesn’t necessarily mean you should sell, says John Stepek.

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The most influential and expensive market in the world

American stocks are looking very expensive, but that doesn't necessarily mean you should sell.

Investors in US stocks today should perhaps think twice, according to investment research group Morningstar. Over the next decade, the asset class will deliver "negligible expected returns after inflation, on our valuation analysis", says Morningstar analyst Dan Kemp on MarketWatch.com. As ever, the problem with the US is that it's "extremely expensive", says Kemp. Based on past performance (which as we all know, is no guide to the future, and yet is also the only clue we have), if you invest when stocks are expensive, then you'll make lower returns over the long run. Buy when they're cheap, and you should make higher returns over time.

Morningstar is far from the only group of analysts to suggest that the US is expensive. Based on one of MoneyWeek's favourite measures, the cyclically adjusted price/earnings ratio (Cape see below), the S&P 500 is currently trading on a multiple of around 33, which is pretty much the highest it's ever been bar the 44 level seen just ahead of the tech bubble bursting. And while the recent corporation tax cuts were good news for company earnings, says Morningstar, it's still the case that "much of the good news is now more than priced into the market, with US shares now trading well ahead of our fair value estimates". There is, writes Kemp, "an elevated risk of a permanent loss of capital from these levels".

The problem for investors is this: at the end of the day, US stocks have been expensive on a wide range of measures (not just Cape) for a very long time now. But if you'd sold out of the market entirely on that basis, you'd most likely be kicking yourself right now, as the US has continued to be a strong performer among global markets. The fact remains valuation is a good guide to long-term returns, but you can't use it to time the market.

So how can you use it? To guide your asset allocation. Firstly, while the US stockmarket is certainly the most influential equity market in the world, it is currently also something of an outlier US stocks are more expensive than virtually any other equity market by quite a long way. Morningstar's ten-year estimated returns for most markets are a good bit higher than for the US, with the UK large caps in particular standing out as particularly cheap relative to the level of investment risk (Russia is also cheap but the investment risk is far higher). So find cheaper markets, and consider increasing the proportion of your portfolio you want to invest in them. Secondly, if you already own US stocks, there's no need to panic-sell. Instead, you should look at the proportion of your portfolio invested in US stocks, and then take profits if and when gains take your holding significantly over that level.

I wish I knew what the Cape ratio was, but I'm too embarrassed to ask

Investors often use the price/ earnings (p/e) ratio to judge whether a stock is cheap or not. It's a simple measure to calculate (hence its popularity) you simply divide the share price by earnings per share.A low number (below ten, say) suggests that you aren't paying much for each given £1 of earnings, while a high number indicates a stock may be expensive (or growing rapidly).

However, the basic p/e is highly flawed. Using just one year of profits means a stock particularly one in a cyclical business, such as housebuilding can look cheap because profits happen to be peaking at that point, and are set to plunge when business turns back down in line with the economic cycle.

So in the 1930s, value investors Benjamin Graham and David Dodd suggested that analysts should instead take the average of earnings for the previous five to ten years. This smooths out the data, minimising the impact of economic cycles. John Young Campbell of Princeton and Robert Shiller of Yale University revived Graham and Dodd's suggestion in a 1988 paper. This suggested that the ratio of prices to ten-year average earnings was strongly correlated with returns over the next 20 years. Shiller popularised the idea of a ten-year cyclically adjusted price/earnings ratio (aka Cape) in his book Irrational Exuberance and hence it is sometimes known as the Shiller Cape. It also helped that the first edition of the book which flagged up that the US stockmarket was extremely expensive in Cape terms was published at the very peak of the tech bubble in March 2000.

Cape also highlighted that the US market was (albeit very briefly) unusually cheap after the 2008-09 financial crisis. It has been shown to work in other global markets, too. Currently the US market is very expensive when compared with other markets on a Cape basis, although it is still less overvalued than it was in 1999.

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