US Equities Rally — Is There an End ‘Round the Bend?

Published on 13 Sep, 2017

Views around the US equity market hitting a ceiling and calls for diversifying away to Europe or even away from equities into real assets and precious metals have grown recently. As such, we went back to take a look at the current US market valuations, and compared them across parameters in history. It is hard to find a metric on which the US equities do not appear expensive; not just in the past decade or so, but across a much larger span of historical time.  

We agree that the macro data coming out of the economy isn’t worthy of alarm bells yet, but the rally in US equities sure seems to expect even greater things than what the main street has been able to deliver since the Great Recession. Our note is merely an attempt to evaluate a bearish view with data as it appears today and letting the reader draw conclusions. Therefore, our analysis restricts itself to an absolute comparison of the US stock market as opposed to a relative one with Europe or Emerging Markets.

The S&P 500 has registered a 10% CAGR in returns for the past seven straight years. Sure, there have been speed bumps in between, but investor preference for US equities has just not dwindled. On a 12-month forward basis, the S&P 500 is currently trading around 24.5x, which (excluding the abnormality of the 2008-09 market crash) is in-line or only marginally below the peaks seen just before the bear runs seen during the early-90s and the Great Depression. Further, the current forward multiple appears to be higher than almost all other periods that preceded a meaningful market crash over almost the past 120 years. More recently, the current forward P/S ratio is at its highest in the past two decades, even higher when compared to the peak seen in the dot-com bubble era.   

The S&P 500 12-month Forward P/E

Such bull-runs do warrant a back-to-the-school analysis of the fundamentals and return drivers.

Many would agree that a big part of equity returns come from dividends and free cash flow growth. Of the two, dividends, as the data would suggest, have shown a sustained level of growth. The annual real dividend (adjusted for inflation) CAGR over a 20 year period, considered for as far back as 1891, has increased at a steady clip since mid-2010 and is now at a level last seen nearly 50 years ago. Whether dividends would be able to maintain such growth in the medium term to justify the current market valuations is the big question. Free cash flow on the other hand, has not been able to match that growth. Annual free cash flow’s 5-year CAGR considered over the past 27 years shows a drop in growth during the past four years. That said the current FCF yield of around 4.5% is still only slightly below the 27 year average. 

From a valuation point of view, we considered Shiller CAPE (Cyclically Adjusted PE) but have gone back 20 years to absorb the effects of a much bigger cycle and to weed out the impact of the ‘08 recession as much as possible. We note that the current CAPE is higher than what was observed just before the Great Depression.

The only time in history when the US market valuation, adjusted for cyclicality, was more expensive was during the dot-com bubble. That sure does not look like a great sign if one is evaluating investing in equities. We mapped this CAPE with 20-year earnings CAGR over the past 120 years. We notice a steady decline in earnings growth just before a crash, during times of overvaluation. The current trend of the past four to five years appears similar.

We also note that dividend growth, in the past, has tended to decline ahead of a market correction. That is when a market correction is driven by an expected weakness in consumer and industrial sectors. We do not see material signs of that happening yet, not when the US GDP growth expectations are in the 1.5% to 2.0% range. Much of the rally, as we pointed out earlier, seems to be coming from a sustained growth in dividends and of course, multiple expansion. We believe multiple expansion in part has been driven by lack of options in equity investing outside of the US. Europe has taken forever to recover and China hasn’t helped EMs’ cause.

S&P 500 Cape vs. 20 Years Real Earnings & Dividend CAGR

Historical dividend yield has averaged sub 1.5% for some time now and the drop is in-line with market corrections that have happened over the past several decades. With the market banking on dividend growth to sustain, free cash flow growth does not seem to support that. And for the US economy to go past the 2% mark in the near-term, capex cycle would also have to be maintained. To be clear, economic slowdown is not the worry right now, it is the basis on which market valuation seems to have been pegged that could cause investors to start a careful evaluation.

FCF Yield vs. 5 Year FCF CAGR

That being said, fund flows are nowhere near indicating a pull back. 2017 YTD has seen net inflows in US ETFs to the tune of nearly US$200 bn. Most would agree that a bull-run such as this would eventually take a breather but not many are able to put a finger on that one big trigger. A new president in the White House has so far, rather surprisingly, been taken positively by the market. Perhaps his foreign policies, especially in the Korean peninsula, could be that trigger.