Can U.S. stocks continue to advance given their rich valuations that appear disconnected from fundamentals?
It’s a question that many advisors are asking following 2019’s 28% gains in the S&P 500 despite negative year-over-year earnings growth for at least the first three quarters (fourth-quarter earnings aren’t all in yet).
Since 2007, the S&P 500 has returned 7% after accounting for inflation versus 1.85% for the rest of the world, even though the U.S. economic expansion, though the longest, has been one of the weakest; productivity growth has lagged GDP growth; and real wages, adjusted for inflation, has been essentially flat, according to James Montier, a member of the asset allocation team at Grantham Mayo Van Otterloo & Co.
Add to that the growing income inequality gap, with the top 10% of income earners collecting two-thirds of income growth — which is “a real problem for any society” — and the increase in corporate debt, now at its highest percentage of EBITDA since the early 2000s, said Montier who spoke at the Inside ETFs conference in Hollywood, Florida.
Earnings per share adjusted for inflation have risen an average 2.14% annually between the first quarter of 2007 and first quarter of 2019 — “not much better than GDP” — but they’ve been supported heavily by share buybacks financed by corporate debt, according to Montier.
The Shiller price-to-earnings ratio, which incorporates the average inflation-adjusted earnings from the previous 10 years, stands at 30 times for the S&P 500 versus 15 times for the rest of the world and 13 times for emerging market stocks.
“There are risks out there, and those risks are probably not worth paying the premium multiples,” said Montier. A collapse in cash flows is the key threat for the U.S. investors, he said.
“How likely is it that valuations will keep increasing in U.S. stocks and buybacks continue?” he asked. “We are in the realm of extreme beliefs.”
Quoting Robert Rhea’s “The Dow Theory” published in 1932, Montier noted that the third and final phase of a bull market is “the period when speculation is rampant. When stocks are advanced on hopes and expectations.”
GMO does not own U.S. stocks and favors emerging market stocks. Its benchmark-free allocation strategy is 50% stocks, including 28% emerging market stocks, 17% developed markets excluding the U.S., 26% alternatives including systematic global macro and fixed income absolute return, 22% fixed income and 2% cash.
— Check out GMO’s Montier Warns: Beware of Rosy Forecasts on ThinkAdvisor.