Ride it out: what to do if the US market begins to topple

Should investors in US stocks ride out the uncertainty or leave the market?

Mark Atherton
thetimes

Wall Street has been defying expectations for the past decade. Despite predictions to the contrary, the election of Donald Trump fuelled a further rise in share prices. In 2017 the Dow Jones Industrial Average clocked up 71 record highs in 12 months, the most in any single calendar year. This week the president’s decision to leave the Iran nuclear accord struck in 2015 has fuelled oil stocks.

As a result, US shares are standing on a valuation higher even than the periods just before the Wall Street crash of 1929 and the financial meltdown of 2008. This is sparking fears among some investors — should you share their view if you have money in funds that hold some, or large, amounts of US stocks?

High valuations
[post_ads]In its latest analysis of global equity markets, Star Capital, the private equity company, ranked the US as the fourth most expensive in the world, behind India, Switzerland and the Philippines. Brian Dennehy of Fundexpert, the fund research website, says that on one key measure of valuation, the Shiller CAPE (cyclically adjusted price to earnings) index, US shares are trading on 32 times earnings, a higher figure than was reached just before the Wall Street crash and the 2008 credit crunch. A study by Deutsche Bank, using a method of valuation known as the price-to-book ratio, produced a similar result. It showed that US companies’ share prices were, on average, trading at three times their book value, whereas European companies were trading at 1.9 times their book value.

The debt mountain

Another factor that should give investors pause for thought is the sheer size of the debt burden weighing on the US economy. The government’s debt ceiling has just been raised again, and corporate and consumer debt have been increasing too. Russ Mould of AJ Bell, an online wealth manager, says: “America’s total debt pile comes to about $60 trillion, and the really bad news is that the figure has grown by $7.6 trillion over the past five years, compared with an increase in GDP of only $2.7 trillion. In other words, the US is having to borrow more to keep the growth show on the road and getting diminishing returns from every buck it borrows.”

The wider perspective

Given these sky-high valuations and rising debt, it is no surprise that investors are hesitant to invest in what could be the final stages of the long-running US bull market. However, William Sobczak of Kepler Partners, an investment trust specialist, says this higher level of valuation is a persistent feature. He says the same Deutsche Bank study that highlighted the valuation premium also showed that it is not a new phenomenon.

Over the past 20 years US companies have consistently had a price-to-book ratio almost 50 per cent higher than that of European stocks. Before investors rule out the US on price grounds, it makes sense to understand why this valuation premium exists.
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First, he says, US companies tend on average to perform better than their European rivals when measured by several key yardsticks. Between 1997 and 2005 the annual return on equity in the US was significantly greater than it was in Europe, helping to explain the big valuation premiums.

Second, these higher returns have been driven by fatter profit margins in the US, a factor which has been boosted by the greater market share that the dominant US companies in each sector enjoy when compared with their European rivals.

More benign US regulations and tax laws have also contributed to superior returns from the other side of the Atlantic, says Mr Sobczak. “Although the nominal rate of US corporation tax seems high, the actual rate paid by the largest US companies is lower than that paid by their European counterparts.”

Mr Sobczak says: “US equity markets seem expensive on a relative basis. However Deutsche Bank’s report suggests that companies based in the US have more attractive characteristics than those in other regions. That is not to say that investors won’t still take flight, because the perception remains that US equities are expensive, but whichever way the cookie crumbles, the US remains a key element of most diversified portfolios.”

Ways to play the US

Kepler’s study of more than 100 US unit and investment trusts designed for UK investors shows that only 25 per cent beat the main US index, the S&P 500, over the past five years. It is understandable that a number of investors will opt for a tracker fund. However, if you do some research you should be able to find a good actively managed fund. Look for funds that don’t follow the herd, but have a clear and distinct investment process.

Examples are the Artemis US Select and US Smaller Companies funds, where the manager, Cormac Weldon, actively seeks out stocks that are less vulnerable to the “Amazon effect”, which is disrupting so many stocks and sectors. Another option is to go specifically for US smaller company stocks, which have outperformed their larger rivals over three, five and ten years. A third, potentially high-risk, high-reward route is to embrace funds investing in technology stocks, which have played a big part in driving US markets higher. They stand to do well if markets continue to rise, but are likely to be among the first to suffer in a fall.

The expert picks

[post_ads_2]William Sobczak of Kepler Partners goes for JP Morgan US Smaller Companies investment trust and Allianz Technology trust. “The managers of the JP Morgan trust buy high-quality smaller companies that generate consistent earnings growth. The Allianz trust backs companies engaged in innovative disruption in sectors as diverse as automobiles, advertising, retail and web services.”

Jason Hollands of Tilney goes for the Dodge & Cox Worldwide US Stock fund and the Loomis Sayles US Equity Leaders fund. “The Dodge & Cox fund filters out overvalued stocks. The Loomis fund is a concentrated portfolio of companies, with a focus on intrinsic value rather than price/earnings multiples.”

James McManus, an investment manager at Nutmeg, the online wealth manager, likes the Xtrackers S&P 500 Ucits exchange-traded fund (ETF) and the PowerShares EQQQ Nasdaq 100 Ucits ETF. “The Xtrackers provides investors with low-cost access to the largest 500 stocks in the US, while the PowerShares includes stocks that benefit from technology trends.”