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How expensive is the US stock market?

We take a deep dive into the outlook for the US economy and stock market.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

In the short term markets are driven by investor sentiment. News stories, good and bad, influence how confident we feel about the prospects for businesses and the economy, which creates volatility in the market.

Over time the noise fades. If you look at the market over a few years, you’ll be able to pick out periods when investors felt especially gloomy or optimistic. Step back and look at performance over decades, and a different picture emerges. The direction of the market is driven by the success of the companies within it, and based on their earnings and profitability.

2019 was a great year for the US market. The index smashed through all-time highs and delivered its second biggest annual gain of the millennium.

Will the US market go from strength to strength? Or could we be looking at a bubble?

Is the US overvalued?

We can value a market a few different ways, but the most common measure is the price-to-earnings (P/E) ratio. The calculation is simple, take the price of a share, or market, and divide it by how much profit is being made. The aim is to reveal how much investors are willing to pay for one unit of earnings. A P/E ratio of 30 means investors are happy to pay 30 years’ profit for a slice of the action.

Today, investors are willing to pay about 25 times the US market’s earnings, which pales in comparison to the heights of the dotcom boom, where the P/E ratio peaked at 32. Sounds appealing doesn’t it?

Do earnings and prices move together?

Y axis shows earnings and index level rebased to 100.

Past performance is not a guide to future returns. Source: Refintiv to 31/12/2019.

You can see in the graph above that earnings and prices haven’t always moved together. In the latter stages of the dotcom bubble (between 1998 and 2000), the soaring stock prices of many internet-based companies pushed the US index higher as valuations outpaced earnings growth.

Now it’s a different story. In the first part of the current cycle earnings were ahead, they grew strongly before slowing around 2015. More recently earnings and valuations have been growing similarly.

However, over a business cycle company earnings can fluctuate. When the economy’s expanding you’d expect to see rising earnings and profits; in a recession you’d expect to see them fall. We can account for these cyclical effects with the CAPE ratio or ‘Cyclically Adjusted Price to Earnings ratio’. It averages the last 10 years’ of earnings and adjusts them for inflation, instead of just using last year’s earnings.

Recent CAPE data shows the US market as the third most expensive in the world. When the CAPE ratio of the market is high it indicates stocks could be overvalued which means future returns are more likely to be lower.

It’s important to remember that these companies don’t operate in a vacuum. Their environment matters – and an important part is the interest rate. Interest rates are used to price future cash flows from companies. When rates are lower, future growth in profits and cash flows are more attractive to investors. This makes them willing to pay a higher price to own the company’s shares driving the index higher.

Where could interest rates go next?

The Fed dropped interest rates three times in 2019 to combat the economic slowdown. Lower rates make borrowing more attractive for businesses, offering them cheaper cash for investment. Businesses have taken full advantage and corporate debt levels have reached record highs.

But this hasn’t been enough for Trump, he wants rates slashed to zero or lower to boost the economy. Fed Chairman Jerome Powell holds a different view. He’s repeatedly spoken about the risks associated with such high levels of corporate debt. When rates rise, these companies will see their interest payments rise too. Businesses who overstretched themselves could be in trouble.

We expect those hoping for further rate cuts will remain frustrated. The Fed’s made it clear they have no further reductions planned unless economic data deteriorates significantly.

What is the impact of the trade war with China?

Underlying the trade war is Trump’s view that the US is being unfairly treated by China when it comes to trade. He frequently cites the country’s trade deficit as evidence of this as well as intellectual property concerns. But Trump can’t afford to let trade uncertainty eat much further into US growth. After all, no US President has been re-elected for a second term while the economy is in recession.

The recent signing of the ‘phase one agreement’ by the US and China might reflect a thawing of sorts in relations. But the unfortunate reality is that only a small proportion of the tariffs imposed will actually be reversed. Tariffs are set to remain on around two-thirds of the goods America imports from China.

Trump’s harder line approach to trade with China is supported by an unlikely ally though in the shape of the Democratic Party, so markets could have to contend with the twists and turns of the trade war for some time to come.

Tweets from President trump

On days when Trump tweeted more than 35 times the stock market fell

When Trump tweeted fewer than five times the market rose

Is this a case of less is more?

Source: Bank of America.

What could the future hold for the US market?

It’s a question investors around the world will be pondering.

A meaningful resolution to the trade war with China has the power to boost confidence in the economy, and nudge markets higher again. But the phase one deal looks anything but meaningful.

If further progress on trade isn’t forthcoming and growth continues to slow, its possible eyes will turn to the central bank for another rate cut. But this could be a risky tactic for the President, and possibly one he won’t be willing to take.

Trump is already campaigning to be re-elected and this means keeping the economy on course. He’ll want US consumers and businesses heading into the voting season feeling comfortable and confident. This is likely to mean no sudden moves from the main man at the wheel.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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