As my colleague Ed Bowsher pointed out yesterday, US shares look overvalued compared to the long-term.
And to be honest, they look pretty expensive in the short-term as well.
That doesn’t mean they can’t keep rising. But it does mean that you’re taking a big risk by piling into a general tracker or active fund with lots of exposure to the US.
However, there are still some pockets of value out there – you just need to know where to look…
The US market looks overvalued on most measures
There are plenty of reasons to be nervous about the price of the US stock market. Ed looked at the cyclically-adjusted price/earnings (Cape) ratio yesterday, for example.
But there are plenty of other examples to point to. Robert Royle of Smith & Williamson North American Trust, for example, is worried by the amount of margin debt that investors are taking on.
Margin is basically a way to buy shares with borrowed money – it’s similar to spread betting.
For example, you could buy £10,000 worth of shares by putting down £1,000 and borrowing the other 90%. If the value of the shares rises by 10% to £11,000, you could sell out for a £1,000 profit. That’s a 100% return on your initial investment.
Trouble is, in a bull market, people forget the flipside. If the underlying share price had dropped by 10%, you’d be wiped out. So this is an incredibly risky form of investing. While some investors can handle it, when everyone starts doing it, it’s a sign that things are spinning out of control.
In the years before the 1929 crash, brokers were notoriously allowing investors to buy shares on credit, no questions asked. Margin debt shot up sharply before the end of the tech bubble in 2000, and also in 2007. So the fact that it’s back at record levels now bodes ill.
Corporate profit margins are another issue. They’re currently at record levels. That might sound good, but history suggests not – it means the only way is down. The long-term average is more like 6%, compared to today’s 9.3%.
You’ll hear lots of reasons why this sort of thing is sustainable right now. But you always hear justifications when prices are too high. People have to find reasons to stay bullish – it’s the way market psychology works.
Two good-value trades on the US economy
Of course, none of this is any use in terms of market timing. It simply tells us that the market is currently over-valued, and so in the longer run, it’s not a ‘buy and hold’ trade right now.
If you buy the market today, you have to assume that you are going to be able to get out at a higher point some time before it crashes. Collective experience suggests that this is a very risky bet.
And given that you’re not a fund manager who has to beat a benchmark, or stay invested, it makes far more sense to simply invest in something else instead – something that actually represents some sort of value.
But it’s also a shame to neglect the world’s biggest economy – and arguably one of the healthier developed economies – completely in your portfolio. The good news is that not every US-related company is ridiculously overpriced. Here are two options you might want to consider.
Outerwall (NASDAQ: OUTR) runs two businesses – vending machines (DVD) and coin counters (which automatically sort change). This is the sort of business that fulfills a basic demand (in this case convenience) while remaining niche enough to discourage competitors.
While growth is expected to continue at over 5% a year, the need for investment in machines is expected to dramatically fall. That in turn should lead to a sharp increase in free cash flow.
The firm has said that, instead of plowing money into new ventures, it will return this cash to shareholders, probably through buybacks, which will help boost the price further. It currently trades at only 12.2 times 2014 earnings.
For a US trade that’s closer to home, you could look at Rentokil (LSE: RTO). Previously known best for its sprawling collection for companies, Rentokil has never really recovered from the collapse in its share price in the late ‘90s.
However, as Chris Ford, co-manager of the Pictet US Equity Fund, points out, it’s now far more focused on its core business of pest control, which now accounts for the majority of sales.
That’s good news because the US is going through something of a pest epidemic right now – bedbugs have re-emerged as a major problem. To bolster this market, Rentokil recently bought US group Western Exterminator.
Rentokil currently trades at 11 times 2014 earnings, and pays a dividend of 2%. This makes it much cheaper than its major US competitor Rollins, which trades at a whopping 31 times next year’s profits.
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