US stocks look expensive – here’s what to own instead

The US stockmarket is the world’s biggest and most important market. It’s also among the world’s most expensive markets right now.

That doesn’t bode well for future returns. So what can you do about it?

The US stockmarket is looking expensive, however you measure it

Here at MoneyWeek, the cyclically-adjusted price/earnings ratio (Cape for short) has long been one of our favourite long-term valuation measures. It was popularised by Yale professor and Nobel prizewinner Robert Shiller in the late 1990s. (Indeed, it’s sometimes known as the Shiller p/e as a result).

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What does it do? A traditional price/earnings (p/e) ratio compares the share price (p) of a company to one year of its earnings (forecast or historic). Or, if you’re looking at an entire index, it compares the price of the index to the combined earnings of the companies that comprise it. The higher the p/e, the more you are paying for each pound or dollar of earnings.

The thing is, one year of earnings might not give you a good idea of whether a market is really cheap or expensive. You might be looking at earnings in a particularly bad year – like 2009, say. Or you might be looking right in the midst of a boom. So earnings might be artificially high or low.

Cape tries to sort this out by taking an average over ten years. This smooths out the ups and downs and thus gives you a better idea of whether investors are actually paying a lot more for average earnings than they normally do.

Cape is based on the idea of “reversion to the mean” – that is, that if a market gets a lot more expensive than its historic average, then it is almost certain to reverse that overvaluation at some point. It’s useless for making short-term forecasts (everything is, which is why technical analysis exists for traders to attempt to manage their risk).

But in the long run, it has a decent record (relative to other valuation ratios at least) of predicting forward returns. In other words, if you buy when a market is cheap on a Cape basis, your returns over a decade should be decent even if it can’t tell you much about the year ahead. And if you buy when it’s expensive – well, you should lower your expectations.

I’m just bringing it up today because I read a few interesting pieces over the weekend about valuations in the US. The subject is probably on the minds of investors and their advisors because shares have had a good run, which is now being interrupted somewhat by the fear of inflation. So it might be time for some bet-hedging.

Michael Batnick on his Irrelevant Investor blog makes the very good point that the Cape of the US market (the S&P 500) has been high compared to its historic average for a long time – since at least 2014, when it rose above 25 for only the third time in a century. And yet, ten-year average annual returns are in line to be the strongest on record after hitting that level (currently running at 14% a year).

Does that mean the Cape is broken? You can certainly make the argument – as Shiller himself has – that low interest rates justify (or certainly explain) the Cape ratio remaining higher for longer. And as Batnick points out, the Cape’s long-term average has risen somewhat over time.

But the good news is that it’s not worth splitting hairs about this. The Cape is now around 37 and has never been higher outside of the tech bubble. Like it or not, says Batnick, “37 on the Cape is a high freaking number”. In short, it’s hard to believe that returns for the next ten years will match the past ten.

Just make sure you’re diversified

So what’s the answer? Batnick, writing for a US-centric audience, suggests that “lowering your expectations makes a lot more sense than making wholesale changes to your portfolio.” This is a fair point, in that there’s no point in selling everything and jumping into cash, because you cannot predict a) when valuations will correct, or b) how it will happen (maybe you’ll just get a long mediocre period with no obvious alternatives, rather than an epic crash).

However, it’s also worth bearing in mind that while the US is important, it’s not the only market out there. As Charlie Bilello of Compound Advisors points out, the US has strongly outperformed international markets over the last ten years. That – despite the sense you may often get – is not a normal state of affairs. There’s no reason for the US to always be the lead market.

So one way of dealing with an expensive US market is simply to invest a decent amount of money elsewhere. Now, bear in mind that the US represents more than half of global market capitalisation. In other words, if you were a purely passive investor who wanted to do nothing more than track global stockmarket returns in the equity portion of your portfolio, then you would want to have about £5.50 in every £10 you invest in the US.

I suspect most of you don’t have anywhere near that amount (and it’s not necessarily the best bet – it’s just to give perspective). My point is more that you shouldn’t sell out of US markets entirely. But while lots of other markets are also expensive, we’re lucky enough as British investors to be very close to one of the few major markets that isn’t outright outrageously so.

Britain’s post-Brexit shunning isn’t entirely over yet, but the more pragmatic business and investment heads have put it behind them, helped by a successful vaccine rollout which has left Britain near the front of the pack in the re-opening stakes.

As The Economist pointed out last week, the UK economy is “poised for a sharp recovery”. Indeed, “the immediate outlook... is rosier than almost anywhere”. Meanwhile, the FTSE 100 “is stuffed with the shares of companies – miners, banks and energy firms” that should outperform “in an environment of rising inflation”. In short, “the case against sterling assets is oversold”.

Not only that, but the FTSE 100 also offers a good dollop of strategic diversification too. The main driver of the recent bull market has been growth stocks. Value stocks have been left lagging – in the US, even value is expensive on an absolute basis, but it’s still very cheap relative to growth. The FTSE 100 – as The Economist quote above alludes to – on the other hand, has plenty of value stocks. As I’ve said before, it’s practically the anti-Nasdaq.

So as we’ve been saying for a while now, make sure you’ve got some exposure, even if it is simply via a FTSE 100 tracker. And if you’re interested in reading more on the topic, make sure you subscribe to MoneyWeek magazine – you can get your first six issues free here.