BLOATED VALUATIONS ARREST U.S. BULL RUN / THE FINANCIAL TIMES

Last updated: March 11, 2015 4:09 pm

Bloated valuations arrest US bull run

Michael Mackenzie
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Entering its seventh year, the ageing US equity bull market looks vulnerable.

Rising concerns about the outlook for US equities reflect their lofty valuations and expectations of higher interest rates. In the past, the combination of rich share prices during periods of tighter monetary policy has proved challenging for the market.

Now, as investors increasingly believe the Federal Reserve may start raising official borrowing costs as early as the summer, equity prices have come under pressure. The S&P 500 erased its 2015 gains on Tuesday as investors have focused on sharp downward profit revisions led by energy stocks and concerns over rising bond yields and the strengthening dollar.

 

Uncertainly over how asset prices will react once borrowing costs rise for the first time since 2006, looms large over Wall Street. Years of low interest rates and aggressive easing from the central bank have encouraged investors to seek equity exposure, while US companies have taken advantage of cheap borrowing costs to help fund huge buybacks and dividend payouts to shareholders.

 

“We have been relatively bullish on the market in recent years and believe the bias for stocks remains to the upside, but investors should be concerned,” says Dan Greenhaus, chief strategist at BTIG.

“One thing is clear, whenever the Fed has raised rates at times when equities are richly valued, it has been problematic for investors.”

 

 

No matter the S&P 500 setting a record close earlier this month, as the Nasdaq Composite briefly rose above the 5,000 point threshold for the first time since the internet bubble, investors entered 2015 worried about high valuations and a mature-looking bull run.

 

Vadim Zlotnikov, chief market strategist at AllianceBernstein, says: “I’m always concerned about environments like this, as there are not a lot of opportunities for value.”

Among the clouds massing on the equity market horizon is the prospect of two straight quarters of negative earnings growth, led by energy companies being hammered by a sliding oil price, and dubbed by some as a “profits recession” during the first half of this year.

 

 

Mr Greenhaus says the forecast declines in earnings mainly reflect the energy sector. “We don’t think this is a good development per se, but we do not think it portends the start of a bear market.”

Michael Stanes, investment director at Heartwood Investment Management says: “At some point earnings do have to come through to support higher valuation multiples,” adding that ‘’valuations are moving back up to levels last seen in 2007”.

To some extent, Wall Street is looking beyond the slide in consensus earnings, due to lower energy prices and those for imported goods boosting the economy. Greater spending power for consumers is seen outweighing the looming hit for company bottom lines. Not surprisingly, analysts are forecasting a rebound for earnings growth during the second half.

But as the dollar continues ascending, global revenues for US multinationals face continued downward pressure, while Treasury yields have risen sharply of late, weighing down the performance of bond-like share market proxies such as utilities and real estate investment trusts.

Jack Ablin, chief investment officer at BMO Private Bank, says US valuations do not compare well with global equities and that buybacks have been a key source of strength for the domestic share market.

“Buybacks are keeping the market afloat and the buyback yield is higher than the dividend yield as the amount of shares outstanding declines,” says Mr Ablin.

With equities on the defensive, uppermost in the minds of some observers is how the current US bull run, at 72 months — and counting, ranks as the fourth longest winning streak since the 1930s, according to S&P Dow Jones Indices. In terms of performance, the S&P 500’s rise of more than 200 per cent since the nadir of the financial crisis in March 2009 pales beside that of the bull run of the 1990s, but is approaching the gain recorded during the 1980s.

Unlike those bull market runs, the current interest rate backdrop is much lower, in part reflecting muted expectations for inflation.

As such, modest tightening from the Fed this year is not seen pushing long-term interest rates substantially higher. A contained rise in 10-year Treasury yields from about 2.1 per cent is likely to sustain the appeal of owning equities even with the S&P trading at 17 times future earnings.

In turn, the current weakness in US equities may well represent another buying opportunity for a bull market that can run a lot further.

“With rates so low, stocks could grow more expensive before they finally reach peak valuations,” says Nicholas Colas, chief market strategist at ConvergEx.