Advertisement

Snap up cheap British stocks

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

904_MW_P14_strategy
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.

Advertisement - Article continues below

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".

Advertisement
Advertisement - Article continues below

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.

Advertisement - Article continues below

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).

Advertisement - Article continues below
Advertisement
Advertisement - Article continues below

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.

Advertisement
Advertisement

Recommended

The British equity market is shrinking
Stockmarkets

The British equity market is shrinking

British startups are abandoning public stockmarkets and turning to deep-pocketed Silicon Valley venture capitalists for their investment needs.
8 Nov 2019
Beyond the Brexit talk, the British economy isn’t doing too badly
Economy

Beyond the Brexit talk, the British economy isn’t doing too badly

The political Brexit pantomime aside, Britain is in pretty good shape. With near-record employment, strong wage growth and modest inflation, there is …
17 Oct 2019
BP has slashed its dividend – and markets love it
Income investing

BP has slashed its dividend – and markets love it

BP has bowed to the inevitable and cut its dividend in half – and its share price promptly rose. John Stepek explains what it means for shareholders …
4 Aug 2020
How safe are your dividends?
Income investing

How safe are your dividends?

Dividend investing can be a great strategy. But how can you avoid the stocks that are liable to cut your income? Phil Oakley explains.
4 Aug 2020

Most Popular

Can the recent rally in sterling continue?
Sponsored

Can the recent rally in sterling continue?

A "double top"  – a very recognisable pattern – is forming in in the US dollar. Dominic Frisby explains what it is, and what it could tell us about st…
3 Aug 2020
UK banks have had a shocking week – so it’s probably a good time to buy
UK stockmarkets

UK banks have had a shocking week – so it’s probably a good time to buy

Lloyds Bank reported a £676m loss this week. And, with all of the UK's high street banks having a terrible time of things, bank stocks are detested ri…
31 Jul 2020
Gold bugs' dreams are coming true – but we could still see a V-shaped recovery
Gold

Gold bugs' dreams are coming true – but we could still see a V-shaped recovery

John and Merryn talk about how it's perfectly reasonable to expect a V-shaped recovery and to continue holding gold as well. Plus, inflation, staycati…
30 Jul 2020