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Many investors are asking their advisors whether equity markets have peaked. Investors are afraid of expensive valuations, trade tariffs, Turkey, slowing growth in China and the Flattening of the US Yield Curve.
Below I will go through each of these issues, hoping to convince you that the rally in the equity markets still has legs.
I will discuss valuation of the US market since it is the market that investors believe is most overpriced at this point in time.
On valuation, the most overvalued ratio of the S&P 500 is the Price-to-Sales-Ratio. However, it is also true that sales are surging – implying valuations, according to this metric, may be reduced in the future.
The next most expensive ratio is the market capitalization to GDP, Warren Buffett’s preferred market valuation gauge. GDP has been growing at a subnormal rate for eight years, but recently has increased rather dramatically. This suggests this indicator may look more reasonable in the quarters ahead.
As for the price to book ratio, we are of the view that book values are understated. For instance, until the recent corporate tax code, a company would buy a piece of capital equipment and depreciate for, say, seven years, even though the effective life of the equipment was 30 years.
Turning to price to earnings measurements, if you believe S&P’s earnings estimate for 2019 of $177, it is trading at 16x next year’s earnings which is not expensive.
Moving on to trade tariffs, we have said in past articles that we do not think a major trade war is coming. That said, so far there have been 25% tariffs imposed on roughly $110 billion worth of goods ($55 billion by the U.S and the same by China). Last year the total goods relationship between the two countries was some $635 billion. No wonder the stock market is ignoring the trade tiff so far.
The problems in Turkey are rather unlikely to be resolved anytime soon. Fears of a contagion effect have risen, but most other emerging economies are in fundamentally much better shape.
Slowing growth in China
China’s slowing growth is a much bigger risk than any of the aforementioned metrics, but China recently announced a bunch of new infrastructure projects ($11 billion) in an attempt to reignite its growth prospects.
China is caught in a crossfire between a self-induced economic slowdown and trade pressure from the US. As a result, Chinese stocks have sold off lately. We remain confident that once trade jitters calm down, Chinese equities should enjoy a swift recovery.
The flattening of the US Yield Curve
As things stand today, we are not worried about the flattening yield curve because it is driven by short rates increasing at a much faster pace than long-dated rates due to international money flows.
Moreover, if you look at the relationship between the 13-week T-bill and some longer dated Treasury security (the 10-year T-note). Using that as a metric, the yield curve is nowhere near inversion.
The current market environment remains 'risk-on'. The bull market continues to be led by US assets, particularly the so-called FAANMG-stocks (Facebook, Apple, Amazon, Microsoft, Netflix, and Google). High yield corporate bonds and emerging-market debt have also recovered.
The positive sentiment has been helped by the corporate earnings reporting season. It has been very strong, particularly in the US. In addition, macroeconomic data has remained relatively stable at elevated levels both in the US and the Eurozone, while it has been somewhat weaker in China.
Major central banks have maintained their accommodative monetary policies, which continues to be supportive for equity markets. The US Federal Reserve will stick to its gradual approach of raising interest rates. It has not yet reached policy overshoot territory.
For now, investors should ignore short-term macroeconomic data and political noise. Currently, we do not have evidence that liquidity conditions warrant a more defensive positioning in the portfolios.
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