Phil looks at the state of the US stock market following the presidential election and the reasons why it might continue to boom and why it might not.
Even if you don’t invest in US shares, what happens on Wall Street has a big say in how UK shares will perform. A high-flying US stock market can be a tide that lifts all boats. A sinking one usually means a strong headwind where most shares struggle to make gains.
Last week’s US presidential election win for Donald Trump has been greeted with euphoria on Wall Street, pushing the S&P 500 to fresh record highs. The bullish sentiment has been driven by the expectations of big tax cuts for companies and a bonfire of regulations which should give a big boost to company profits.
For some, this could usher in a bull market similar to the roaring 1920s when technological innovation and euphoria pushed stock prices to very lofty levels.
Most people know what happened to share prices at the end of the 1920s. The Wall Street Crash of 1929 led to a very long bear market and weak returns for shareholders for many years.
The current long winning streak of the US market often raises questions on how long it will last and if it will crash, but it seems there are some warning signs out there that investors should probably not ignore.
Will Trump crash the US economy?
While some salivate over tax cuts and fewer regulations, others fret about what big government job cuts and a crackdown on migration might do to the US economy. Fewer jobs and pay packets sucks demand out of an economy as those affected have less money to spend.
The US economy has been very reliant on migrant labour. If a lot of workers suddenly find that they are told to leave the country under the new president’s plans then a labour shortage could cause chaos and push up prices.
The higher inflation that would result could push up interest rates. This is rarely good news for shares as higher interest rates reduce the value of future company profits expressed in today’s money which usually means lower share prices.
The same can be said for higher tariffs that are placed on imported goods. These are paid by consumers and push up inflation which reduces consumer buying power.
Interest rates could also rise if Trump does not bring down the size of the US government deficit. The current government has been spending considerably more than it takes in taxes and has been plugging the deficit by borrowing money from investors.
Will the bond market bite investors?
But what happens if the expected tax cuts don’t increase tax revenues and the deficit balloons?
The yield on the 10-year US treasury – the interest rate the US government has to pay to borrow money for 10 years – has risen significantly in recent years and could keep on doing so if investors believe that debt levels are getting out of hand.
Bond yields have actually been quite subdued after the election. However, it is worth recognising that they are a key determinant of the valuation of all financial assets, especially shares.
Low bond yields justified high price-to-earnings (PE) ratios on shares during the last decade but there will be a level when higher yields bring them down.
The current yield of 4.3% isn’t that level, but over 5% might start to bring them down. It won’t take much bad news on deficits or inflation to get there.
US shares trade at lofty PE ratios
US shares have been expensive for a while, but this hasn’t stopped the market from going up.
Booming profits for technology companies have been a big help and have driven their valuations up and with it the value of the market. At the moment, the S&P 500 trades on a one-year forecast PE multiple of around 23 times which is punchy.
Put another way, the earnings yield (the inverse of the PE ratio) is 4.3% which is the same as the yield to maturity on the 10-year treasury which suggests that stocks are not great value when compared with bonds.
The Shiller PE which measures the value of the US market based on its rolling 10-year average earnings is also looking very elevated at 38.3 times. This is below the peak of 44 during the internet boom in December 1999 but somewhat higher than the 31.5 times seen in August 1929 before the Wall Street crash.
If you look at the biggest companies in the S&P 500, you will struggle to find any cheaply valued shares.
S&P 500: Top 20 constituents
Source: SharePad
When compared with expected growth in earnings per share (EPS) – using a price-earnings growth or PEG ratio – high-flying NVIDIA could still be seen as cheap on a PEG of 0.7 – a PEG below 1 is often seen as good value – but not many shares are on this measure.
High valuations tend to be a forewarning of poor future returns from shares as a lot of future growth has already been priced in.
Investment bank Goldman Sachs points to these high valuations as the reason why it expects average annual returns of just 3% from US shares over the next decade which will be lower than those from US government bonds.
Buffett piling up cash
Perhaps one of the most cautious indicators of the fragile state of the US market is the fact that Warren Buffett has been selling shares and building up the cash reserves of his Berkshire Hathaway company.
Buffett has a canny knack for knowing when valuations are getting too high. He folded his investment partnership in 1969 because he could not see enough attractively priced shares, and he has done well subsequently by avoiding overpriced shares.
2024 has seen Berkshire be a net seller of almost $130bn of stocks which has boosted its cash balances to more than $300bn or practically one-third of its market capitalisation.
Big cash buffers saw Buffett profit handsomely from the fallout of the 2008 financial crisis as he picked up cheaper investments at very attractive prices. The fact that he has been stockpiling cash recently does not mean the US market is about to crash but if history is any guide, could be a sign that the risk-reward trade-off from investing in it is not very good right now.
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