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#Investments — 28.09.2017

Are US Equities Really Overvalued?

Guillaume Duchesne

Following the recent good stock performance, US equities look expensive. But what about other components in US indices?

At the end of September the S&P 500 index hit record levels, so logically valuations are also at a record high. According to the Shiller valuation ratio, created by Nobel Prize Winner, Robert Shiller, (1) US equities in the S&P 500 are trading at a P/E of 30 and a 15-year high. Although we are a long way off the euphoria in the 2000s when P/E averaged 45, this high valuation, in our view, is limiting the upside potential of US indices. At these levels, the US market needs to take a breather. Announcements from the US Federal Reserve—and as a result, movements on interest rates and the dollar—might trigger renewed volatility in the short term, leading to a consolidation in US indices.

Based on Robert Shiller’s valuation criteria, what are the most risky sectors? The table below shows a wide American index (Datastream) by industry.

Sector valuations as at 25 September 2017 based on Shiller’s methodology

Source: Thomson Reuters Datastream, BNPP WM

The conclusions are the following:  

  • It is difficult to identify a really attractive sector at the moment: the Shiller ratio is currently well above its 10-year average for most industries. Some defensive stocks are trading at high levels, having been massively in vogue during a long period of low interest rates. Cyclicals and financials have priced in the good economic newsflow in recent years (improvement in economic growth, higher company earnings).
  • Technology stocks represent nearly 25% in US indices and are largely responsible for the expensive American equities. Although earnings per share has not reached the levels of the 2000 tech bubble (P/E of 150!), it is currently 18% above its 10-year average. Some tech stocks (including the five most popular and best-performers: Facebook, Amazon, Apple, Netflix and Google or FAANG) sometimes reach stratospheric valuation levels. Even though most tech stocks will benefit from a substantial rally in the medium term, underpinned by ever-increasing content, at these valuation levels, the sector is entering risky territory.
  • Only two sector categories are lagging their historical average: i) commodity-related stocks; and ii) discounted stocks, such as food retailing, that are suffering from major structural changes (new entrants, arrival of digitisation).

 

On the basis of valuations and at the present stage of the economic and financial cycle, it is difficult to give clear sector preferences for the US stock markets. Therefore, we have reduced our positions in a number of sectors (banks, consumer discretionary and technology) in recent months. Nevertheless, we continue to like i) energy stocks which are riding the wave of rising oil prices, and ii) pharmaceuticals (solid growth) which have followed an upward trend since the election of Donald Trump.

(1)     The twofold advantage of Robert Shiller’s calculation technique is that it focuses on past profitability of companies (rather than on analyst estimates, which can be unreliable) and spreads it over the long term. This technique gives a more objective long-term valuation ratio.