Why U.S. Stocks May Still Not Be "Cheap Enough"

Prospects for a trade war are having an impact on markets, but for bargain hunters, stocks are still expensive. Russ suggests looking outside the U.S.

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.

Inconveniently expensive

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.