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.
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.
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.
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.