Avoid US stocks – even the Fed can’t keep the market up forever

So the US Federal Reserve bottled it.

Markets were holding their breath on Wednesday. They were worried that the Fed might take away the punch bowl. After all, six years into the wildest money-printing party ever, everyone knows that the only way to avoid a painful hangover is to keep on drinking.

The Fed did remove the word ‘patient’ from its communication. But it also moderated its hopes for growth, inflation and unemployment.

As one analyst put it, the Fed is “no longer patient, but definitely not impatient, yet”.

The back-pedalling helped buoy markets. But maybe they should be more concerned.

US stocks are already in bubble territory – more stimulus or not, can they really go a lot higher from here?

Here’s a surprise – a US government agency warning on the stockmarket

Writing in the FT this morning, Gillian Tett flags up an interesting little report from a US Treasury department called the Office of Financial Research (OFR).

Quite startlingly, it’s carrying a rather bearish message – not what you expect from a US government agency.

An analyst called Ted Berg has clearly taken a leaf out of well-known fund manager Jeremy Grantham’s book. Grantham’s wealth management group, GMO, is one of the best-known bubble experts in the financial industry.

One of Grantham’s key indicators for spotting a bubble is when valuations get more than two standard deviations away from the historic average. A standard deviation (SD) is simply a statistical measure, you don’t need to sweat about exactly what it means. It’s a useful benchmark for spotting if prices are simply high, or insanely out of whack. At the two SD level, you’re looking at the latter.

Berg has concluded in his Quicksilver Markets report that the key US market, the S&P 500, is very near two standard deviations above its historic average. This is 1999, 2000, 2007 territory.

He’s using all the usual measures – the ones we like at MoneyWeek magazine. There’s the cyclically-adjusted price/earnings ratio (CAPE) – which compares prices to average earnings over ten years. That’s at a historic high (though not an all-time high).

There’s Tobin’s Q – which put very simply, looks at what the total market costs compared to how much it would cost to build all the companies in the market from scratch. If the market value is a lot higher than the replacement value of the companies in the market, then it’s overvalued.

Finally, there’s the Buffett Valuation indicator. This looks at market capitalisation compared to a country’s GDP. Again, on this measure, the US market is very overvalued compared to history.

As usual, none of these indicators are any good for short-term timing. There’s no magic number where the market suddenly goes ‘pop!’

And – as many of the more optimistic pundits point out – with interest rates at these incredibly low levels, there’s every reason for the market to be overvalued compared to history.

That’s perfectly sensible. If the ‘risk-free’ rate collapses, then the yield you as an investor demand from other assets collapses too. And when yields collapse, prices go up.

Trouble is, that’s all fine until interest rates rise. And that’s why I think it’s still well worth paying attention to these stuffy old valuation measures that suggest the market is incredibly overvalued.

The market might be able to stay where it is while interest rates are still nailed to the floor. But we are getting to a point where everything ‘good’ that can be priced into the market, must surely be priced in by now.

That leaves it very vulnerable.

How to cope with these markets

So what can you do? My take on it is that if markets are reliant on zero rates to stay up, you might as well stick with markets where central banks are still pretty active. That’s Europe and Japan at the moment.

In MoneyWeek magazine this week, Jonathan Compton looks at some of his favourite ways to play the European market. You can get your first four issues free here if you’re not already a subscriber.

But if you’re interested in finding out more about how an active investor can adapt to these sorts of overblown markets, you should check out an offer from my colleague and regular MoneyWeek magazine contributor Tim Price.

It’s a pretty unusual offer and it’s proved exceptionally popular. If you haven’t had a chance to look into it yet, I’d suggest you do now – it’s not going to be around for much longer.

• This article is taken from our free daily investment email, Money Morning. Sign up to Money Morning here.

Leave a Reply

Your email address will not be published. Required fields are marked *