Why U.S. stocks may still not be “cheap enough”

Prospects for a trade war are having an impact on markets, but for bargain hunters, stocks are still expensive. Russ suggests looking outside the U.S.

Last year’s stellar equity market was notable for its resilience as well as the magnitude of the gains. In 2017 investors simply shrugged off an increasingly unconventional U.S. political landscape. This is no longer proving to be the case. Until recently, events in Washington D.C. were blamed for the volatility, but other catalysts were responsible. Now, policy is having an effect. This, in turn, may be impacting the price investors are willing to pay for stocks.

Why is policy proving more disruptive this year? The simple answer is that the most recent trade dispute has the potential to affect the real economy. Any significant disruption in trade, and by extension the global economy, comes at a particularly inopportune time. For most of the past six months, investors have been raising their expectations for growth in general and capital spending in particular. An ill-timed trade dispute calls both assumptions into question.

Inconvenient Fed path

Perhaps the market could even live with somewhat slower growth if it weren’t for two other inconvenient facts: The Federal Reserve (Fed) is unlikely to bail out stocks anywhere close to current levels and stocks are expensive. On the former, the Fed appears committed to at least three and potentially four hikes this year. Things will arguably have to get much worse for them to deviate from that path.

Inconveniently expensive

On valuations, it is important to note that the market entered February with multiples at multi-year highs. The S&P 500 ended January at nearly 23 times trailing earnings. Outside of the immediate aftermath of the financial crisis, when earnings were depressed, this is the highest multiple since the early 2000s.

Even after the recent correction, you would struggle to characterize U.S. stocks as cheap. The S&P 500 is still trading at 21 times trailing earnings, approximately 20% above the post-crisis norm.

While stocks were able to levitate at high valuations last year, volatility was much lower. As discussed last month, one phenomenon of the post crisis environment is that equity valuations now have a tendency to co-move with volatility. When volatility is low, P/E ratios tend to be higher (see the chart below). This is perhaps a byproduct of the entry of a new, less experienced equity investor, one previously more inclined to own bonds.

cheap_enoughFinal

As a result of this new dynamic, since 2010 a one point increase in the VIX Index has been associated with about a quarter point decrease in equity multiples. Given that valuations were already rich when the VIX, a commonly used measure of S&P 500 volatility, was at 10, a doubling of volatility suggests stocks should be trading closer to 16 or 17 times earnings, not 21.

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Look abroad

The takeaway is not to abandon stocks. The global economy is still in good health, rates remain low and earnings should grow at a healthy clip. What I would suggest: For investors inclined to add during the current weakness, focus on non-U.S. equities, which are more reasonably valued. Developed markets outside the U.S., as tracked by the MSCI ACWI-ex U.S. Index, is trading for roughly 15 times trailing earnings, the cheapest since late ’15. Right now with the U.S. being still the most expensive market and the epicenter of uncertainty, non-U.S. equities offer better value, and perhaps better protection.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

Investing involves risks, including possible loss of principal. International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets and in concentrations of single countries.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of April 2018 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

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