Rational Exuberance - US Equities

John Leiper - Senior Portfolio Manager
Since its low on the 9th of March 2009, the S&P 500 has gained over 277%, the second longest and third largest gain on record. Understandably, many investors are concerned about the size and scale of the current bull market. Contrary to this perspective, bull markets do not die of old age alone. They die because valuations, underlying fundamentals and broader events conspire against them.
US equities are certainly not cheap. This is the case on almost all valuation metrics when compared to their historical averages. However, lower for longer interest rate expectations have raised equilibrium valuations above their historical averages. According to the Fed model, a measure of relative value, US equities are cheap versus bonds.
Since its low on the 9th of March 2009, the S&P 500 has gained over 277%, the second longest and third largest on record. Understandably, many investors are concerned about the size and scale of the current bull market. Contrary to this perspective, bull markets do not die of old age alone. They die because valuations, underlying fundamentals and broader events conspire against them.
US equities are certainly not cheap. This is the case on almost all valuation metrics when compared to their historical averages. However, lower for longer interest rate expectations have raised equilibrium valuations above their historical averages. According to the Fed model, a measure of relative value, US equities are cheap versus bonds.

Equity bull markets tend to end following a period of strong outperformance versus bonds. However, since the financial crisis more money has flowed into bond funds than equity funds and we are not seeing typical signs of euphoria. The technology sector and most notably the FAANG stocks, an acronym representing Facebook, Amazon, Apple, Netflix and Google are responsible for a large portion of US equity market gains. Importantly, technology valuations are still in line with earnings and a far cry from levels observed during the 1990s technology bubble.

Synchronised global growth, trade and leading economic indicators remain positive and continue to support risk asset valuations. US corporate earnings growth, in particular, has impressed this year with further upside potential from prospective Trump tax cuts.

Bull markets typically end following a series of rate hikes and a flattening yield curve. The Fed has started reducing the size of its balance sheet and indicated it will raise rates in December and 3 more times in 2018. Whilst significantly higher interest rates have the potential to dent equity market valuations, this is not yet the case and there is considerable uncertainty surrounding the future trajectory of monetary policy as inflation and wage growth, albeit resurgent, remain subdued.

The S&P 500 has not suffered a correction of 10% or more since February 2016. However, this is not uncommon when compared to other cyclical rallies within secular long-term bull markets. Valuation is an excellent predictor of longer term performance, but has little predictive power over shorter periods.

Bull markets typically end following a series of rate hikes and a flattening yield curve. The Fed has started reducing the size of its balance sheet and indicated it will raise rates in December and 3 more times in 2018. Whilst significantly higher interest rates have the potential to dent equity market valuations, this is not yet the case and there is considerable uncertainty surrounding the future trajectory of monetary policy as inflation and wage growth, albeit resurgent, remain subdued.

The S&P 500 has not suffered a correction of 10% or more since February 2016. However, this is not uncommon when compared to other cyclical rallies within secular long-term bull markets. Valuation is an excellent predictor of longer term performance, but has little predictive power over shorter periods.

We believe it is unlikely the next correction will mark the end of the longer-term secular bull market and that US equities will continue to grind higher over the coming months, possibly years.
This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Tavistock Wealth Limited.

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