The key unknowns in the US equity market
After more than a year of the US equity market trading above long term averages, valuation has retracted to 15x forward earnings vs. the 14.5x median of the past 5 years. The current market P/E is somewhat distorted by the energy sector that is trading at 28x earnings. The market is looking beyond next year’s earnings valley for that sector that has been created by a collapse in commodity prices. Other valuation measures such as dividend yield support the notion of the markets valuation in line with post financial crisis medians. In comparison to other asset classes the US equity market can be argued to be cheap. For most of the 2000s the US equity market P/E has been correlated with US corporate bond yields. This relationship implies that the US equity market should be trading at nearly 19x earnings. While US equity valuations can’t be described as cheap the recent market volatility has created a more attractive entry point for investors.
The domestic US economy continues to recover on the back of an improving labour market and low interest rates; but slowing emerging economies pose a threat to the slope of the US recovery. Emerging markets (including Mexico and Canada) are the final destination of 63% of the total goods exported from the US. Boeing, a top US exporter, has been selling one out of every three 737 aircraft to Chinese customers. Over the next several years US GDP could be shaved by 0.4 percentage points if emerging economies continue to waver.
Federal Reserve policy remains at the forefront of the market’s mind. Expectations for the Fed to begin the removal of stimulus by increasing short term interest rates have been perennially too high for the past several years. The market was increasingly expecting the inflection in the Fed funds rate to occur in the September meeting. However, instability in overseas economies was cited as a factor in the unchanged stance by the central bank. The commentary by senior Fed officials continues to point to the first hike occurring by year end, however key inflation measures remain below the level when the Fed started cutting interest rates in 2007. How the capital markets and underlying US economy respond to higher rates after an unprecedented period of low rates remains a key unknown for investors.
- Strengthening US economy
- US equity market valuation increasingly attractive
- Economic weakness in emerging markets
- Wavering energy sector
Jeff Morris, Head of US Equities, Standard Life Investments
First published in Investment Week, October 14th 2015