Market Observations – Jan 2022
How stretched is the US market?
There is much to admire of the US stock market with US company profits and therefore earnings rebounding materially during 2021. However, comparing the US market index to the World excluding the US market index, the differential in Price / Earnings (P/E) ratios between the two are clear.
JP Morgan show that the P/E discount of World ex US relative to the US market has never been as large over the past 20 years as is near -35% as at 31/12/2021. Confluence this with, in absolute terms, the current US market P/E is high relative to its own history and the forward P/E ratio for 8 of the 10 sectors are trading at a premium P/E relative to their average since 1995, points towards the US market being highly valued and therefore lower expected returns moving forward.
This is partly explained by the important sectors in the US performing well through the pandemic, with the top 6 companies in the index contributing nearly a third of the total returns of the S&P 500 index during 2021, but also earnings have been boosted by consumer demand and business’s ability to reduce costs and increase revenues.
With the Federal Reserve’s projecting three interest rate hikes in 2022, a more aggressive path that was projected a few weeks ago. Markets are running ahead of policy makers prompting government bond yields to rise and to dampen more growth orientated stocks and investors are revisiting their assumptions for valuations.
As the pandemic recovery continues positive but slower economic growth is expected, supply chain disruptions and higher inflationary costs will need to be absorbed by businesses. Stock market returns will depend upon the direction of profit margins with the potential of higher US taxes having a negative impact. While elevated valuations may be an issue for certain parts of the market other developed markets are at their cheapest levels relative to the US for the past 20 years. As the cyclical recovery remains the return outlook for this part of the market remains positive. Furthermore, with a moderately inflationary environment with low but rising rates, equity income is a way to get short duration and inflation exposure into portfolios at relatively attractive valuations.
Chief Investment Officer