US equity valuations: are you on the right side of the boat?
Article | 02 May 2017
As the dust settles on the US election, the US equity market is showing signs of scepticism towards President Trump’s progrowth proposals. But what does this mean for US investors? Simon Laing explains where he is finding opportunities.
It has been a rollercoaster six months in the US equity market, with the election of President Donald Trump adding impetus to the move towards more economically sensitive sectors that had already started to take place. The performance of ‘Trumpfriendly’ industries, such as financials and industrials, in the month after the election was quite staggering as investors shifted to a pro-growth attitude.
We have always said that when one side of the boat gets very crowded, it often pays to make the early move to the other side. What we talk about less often is how difficult that move can be. By definition, being contrarian is lonely; but to be in a position to benefit fully from a reversion to the mean, we believe you have to invest early when others do not. The sharp moves in the equity market after the US election on 8 November 2016 illustrate this well. It was a mad dash to the other side of the boat, and the result was impressive. The banks sector rose 9.8% over two days. On both days, the volume of shares traded in the sector was nearly 2.5 times the daily average. These are powerful moves that are nearly impossible to capture unless you are invested before the event. Then, with the benefit of hindsight, the event gets renamed the ‘catalyst’.
But since early December 2016 and through year-to-date 2017, although the equity market has continued to rise the undercurrent has been one of scepticism. A look at sectors in the US year-to-date shows technology, consumer staples (including stocks such as food, beverages and other household items) and healthcare as the best performing, with stocks in financial institutions trailing the market. The enormities of Trump’s tasks are beginning to dawn on investors. He is learning how frustrating politics can be compared to the private sector. His healthcare reform has been tough to get through the US Congress, and this in turn has delayed the start of Trump’s promised tax reform. It’s even got people doubting his ability to make any changes. And therein lies the opportunity.
Changes are coming, and we feel confident that many aspects of Trump’s policies will make it into law. But we do doubt the scale of these changes. As we pointed out before the election, the US constitution is a system of checks and balances such that the President does not wield dictatorial powers. Thus, the aggressive policy targets of Trump (15% corporate tax, 4% economic growth, complete Affordable Care Act repeal, Mexican Wall, etc.) are unlikely to be achieved in full. But we never thought they would be. They were the opening gambit in what is a negotiation. We feel pretty confident that there will be broad reforms that will benefit the US economy; but they may take a little longer to be approved than was first thought and will most likely come in a little lighter than initial expectations.
Nonetheless, in our view, this is still good news and should support an uptick in economic expectations in the US. The question becomes: What has the equity market priced in already? In some sectors, it seems we are already pricing in quite a lot. Figure 1 shows how expensive or cheap US equity sectors are trading at versus their own stock price history.
Source: Citigroup, as at 1 February 2017. US equity sectors are as defined by the Global Industry Classification Standard industry group, developed by MSCI and Standard & Poor’s (S&P) for use by the global financial community.
Taking a closer look, we can see that several equity sectors are well above where they have traded historically (the pink line in Figure 1), past what Citigroup calls the ‘bubble threshold’, where stock valuations are historically unsustainable.
When we started to build up our portfolio positions in banks, that sector was firmly at the bottom of the graph and was below the zero line, showing it was actually cheap compared to its valuation history. Following the post-Trump stock market rally, that is no longer the case. The bank sector still looks attractive to us, but less so than in October 2016. From a position where we felt that there was nothing in the valuation of banks for interest rate increases and stronger growth, there now appears to be quite a lot reflected in the price for these improvements. But the potential for reduced regulation and better capital returns is another benefit of the Trump administration, and another leg to the financial story. So we think there is still more to go for in the bank sector − but the best returns for this sector have probably been made.
Are we there yet?
The other story of 2017 so far is the collapse of the price for West Texas Intermediate (WTI) crude oil below US$50 per barrel. As oil prices rose and stabilised last year, shale oil companies in the US took advantage and started to drill more aggressively in the most productive sedimentary basins (mainly the Permian Basin in Texas). Despite the Organization of the Petroleum Exporting Countries (OPEC) cutting oil production to reduce the oversupply and remaining compliant to their promise agreed upon in 2016, the market has got very worried about increasing US oil production and the fact that the US stockpiles of crude product don’t seem to be going down.
While the US oil stockpile situation has been frustrating, it has become a myopic focus for some investors. Unfortunately, the only weekly data release in the oil and gas sector is that of US production and inventories. While it can be important (although the data is incredibly volatile and inconsistent), it disregards what is happening elsewhere in the world despite the fact that oil is a global market. Our analysis suggests that this market is coming into balance, albeit a little slower that we would have hoped. But once we start to see a consistent draw in oil inventories, the market will realise that shale oil increases will be a necessity to meet growing demand because production in the rest of the world is in decline and, in our view, will likely remain so for the next year.
Referring back to Figure 1, the great news is that energy is the only US equity sector trading at a discount to where it has historically been valued. It is also the standout underperformer year-to-date 2017 in the stock market. We are once again standing on the other side of the boat, and it is a very lonely place right now.
Where Simon Laing has expressed opinions, they are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco Perpetual investment professionals.