US stocks have been largely impervious to the brewing turmoil in
emerging markets, so far this year, hovering near record high levels
even as stocks in the latter are being buffeted by trade tensions and
contagion fears. We discussed this divergence in recent issues.
Chart 1: Divergence in performances for US market and rest of the world
In fact, the US market has continued to rally despite many a market observer calling for caution on the back of high valuations for some time now. In a way, the fact that these narratives exist is good – it means that investors are not irrationally exuberant.
That said, are US stocks overvalued now that prices are, once again, near record highs? And is there further upside?
Chart 2 tracks the historical price-earnings ratio (PE) for the S&P 500 index and Dow Jones Industrial Average since the start of 2003 while Chart 3 shows the same for the tech-heavy Nasdaq and S&P 500 Information Technology sector.
Chart 2 and 3: Historical PE ratios for US stock indices
Without doubt, PE valuations (for all the indices) have been trending higher since the global financial crisis in 2008. This means that share prices have been rising faster than corporate earnings growth, which is not totally surprising given the depth of the crisis.
Of note though, the PE multiples for the broad-based S&P 500 index (and the Dow) has started falling for the better part of this year. Both the index and its PE hit a high in January 2018 before correcting lower. However, whilst the index has since rebounded – now just a shade below its January all-time high levels – its PE has fallen (see Chart 4).
Chart 4: S&P 500 index rebounds to near all-time high but PE has fallen
In other words, earnings growth has finally caught up and is now outpacing price gains. Trailing PE for the S&P 500 dropped below 21 times from a year-high of 23.4 times in January.
US corporate earnings growth started picking up steam in 2H2017 and was further fuelled this year by massive tax cuts. Earnings growth hit 25% y-y in the latest 2Q2018 quarter, the strongest pace since the 3Q2010 post-crisis recovery.
Not only are incomes being taxed at lower rates, big corporates are also repatriating billions of cash parked overseas, a good portion of which has gone to finance share buybacks (thereby boosting earnings per share).
There will be some tailwind from tax reform, deregulation, low unemployment, improving productivity and robust consumer confidence. The latest employment data showed signs of stronger wage growth as unemployment remains at a low 3.9%.
US corporates should continue to see double-digit clip of earnings growth in 2H2018, although perhaps slightly slower than the blistering pace in 1H2018. Analysts forecast roughly 20% y-y growth for 3Q2018. This would lower the forward PE for the S&P 500 to around 17-18 times.
For comparison, the index traded between 11 and 26 times and averaged 17.8 times in the past 16 years (2002-2018). If we were to go back even further, PE ranged from 12-30 times and averaged 19 times between 1988 and 2018. Therefore, whilst prevailing prices are not cheap, they do not appear overly expensive either.
Looking beyond 2018, corporate earnings growth is currently expected to moderate to around the mid to high single digit clip, without tax boost. This means that future gains for the S&P 500 would likely be more modest, if valuations are to remain steady.
One could even argue that PE for the S&P 500 should be higher compared with historical averages – due to the increasing influence of higher growth technology stocks. Over the longer-term, their prospective growth will almost certainly exceed those for non-techs such as consumer staples, discretionary and traditional retail, utilities, financials, etc.
Looking at valuations from yet another perspective, bonds compete with stocks for investment dollars. Therefore, we could also compare the yields (returns) from both to determine their relative attractiveness.
The forward earnings yield (which is the inverse of PE multiple, estimated at 18 times) for the S&P 500 is roughly 5.5%. The 10-year US bond yield is hovering just under 3%. From a historical point of view, whilst the equity-bond yield gap has narrowed from five years ago, it is still fairly decent at over 2.5% currently. (See Chart 5)
Chart 5: US equity and bond yields over the years
Bond yields have been anaemic for years because of low inflationary expectations – due to tepid wage growth, digitalisation, globalisation, etc. – and may well stay low going forward given the added disinflationary effect of a strong greenback.
At some point though, the current expansion would come to an end, as dictated by economic cycles – we just don’t know when or why. It could be because of escalation in trade conflict and tariffs or unsustainable debt levels or other events currently unforeseeable.
Table 1: Historical PE range for S&P 500 (2002-2018)
Meanwhile, valuations for the rest of the world have fallen. Chart 6 shows that most Asian markets are now trading at lower valuations compared to US stocks. PE for the MSCI Asian index has fallen below its 10-year average, though still higher than recent crisis valuations (see Chart 7).
US stocks are being driven higher by strong earnings growth and liquidity inflow. The opposite is true for the rest of the world. In other words, lower PE markets may not really be ‘cheaper’ relative to their prospective growth.
It is worth noting that there are few significant tech players outside of China (and those listed in Hong Kong). Hence, bellwether indices for most of these markets mostly consist of stocks from financial services, commodity, telecommunication, consumer and manufacturing sectors – traditionally lower growth companies.
Asian markets also face rising risks – and likely corporate earnings downgrade. Perhaps not so much in terms of contagion from brewing crisis in Turkey and Argentina – which are precipitated by domestic events – but certainly from US tightening and trade conflict.
Emerging markets have been the biggest beneficiaries of unprecedented quantitative easing by the US Federal Reserve. For nearly a decade, the surge in cheap money spilled over into these markets in search of higher yields, lifting asset prices and financing growth through debt. These countries will now suffer the reverse.
The Fed has started shrinking its balance sheet – the amount will rise to about US$50 billion a month come October – and raising benchmark interest rates at a steady pace, underpinned by its robust economy. Furthermore, widening fiscal deficit means the government will need to borrow more money going forward.
In short, liquidity will continue to tighten and capital will be drained from emerging markets and flow back into the US. Some countries, including Indonesia, Philippines and India, are being forced to hike rates in tandem with the Fed, to support their currencies.
The European Central Bank is also poised to end its quantitative easing programme by end-2018.
The combined global liquidity contraction will damp growth at a time when the world’s economy is already slowing and under further threat from trade tensions. All these may well, eventually, filter back into the US economy (as well as that of other developed nations). Remember, Asia and especially China account for a material percentage of the global economy and growth.
At some point, the divergence between US stocks and the rest of the world will hit an inflection. But for the moment, the US is the beneficiary of the unfolding turmoil in emerging markets, while the latter undergo painful adjustments to the new environment.
Performance Comparison Since Inception (%)
%-258.9-10-505101520253035404550556065
A Note to Readers
It is my pleasure to share with you my Value Investing Portfolio. However, I must emphasize that it is by no means a recommendation or a solicitation or expression of views to influence you to buy or sell any stocks. I am just sharing openly on what I am doing with my stock portfolio.
Further, I like to remind all investors that investing is not just about the profits or returns. You will inevitably suffer stock losses too. You need to understand your own investment objective, risk appetite and the amount of loss you can afford to bear. So, while many investors talk only about absolute returns, I am also sharing the computed risk-weighted returns of my portfolio.
Tong Kooi Ong
Chart 1: Divergence in performances for US market and rest of the world
In fact, the US market has continued to rally despite many a market observer calling for caution on the back of high valuations for some time now. In a way, the fact that these narratives exist is good – it means that investors are not irrationally exuberant.
That said, are US stocks overvalued now that prices are, once again, near record highs? And is there further upside?
Chart 2 tracks the historical price-earnings ratio (PE) for the S&P 500 index and Dow Jones Industrial Average since the start of 2003 while Chart 3 shows the same for the tech-heavy Nasdaq and S&P 500 Information Technology sector.
Chart 2 and 3: Historical PE ratios for US stock indices
Without doubt, PE valuations (for all the indices) have been trending higher since the global financial crisis in 2008. This means that share prices have been rising faster than corporate earnings growth, which is not totally surprising given the depth of the crisis.
Of note though, the PE multiples for the broad-based S&P 500 index (and the Dow) has started falling for the better part of this year. Both the index and its PE hit a high in January 2018 before correcting lower. However, whilst the index has since rebounded – now just a shade below its January all-time high levels – its PE has fallen (see Chart 4).
Chart 4: S&P 500 index rebounds to near all-time high but PE has fallen
In other words, earnings growth has finally caught up and is now outpacing price gains. Trailing PE for the S&P 500 dropped below 21 times from a year-high of 23.4 times in January.
US corporate earnings growth started picking up steam in 2H2017 and was further fuelled this year by massive tax cuts. Earnings growth hit 25% y-y in the latest 2Q2018 quarter, the strongest pace since the 3Q2010 post-crisis recovery.
Not only are incomes being taxed at lower rates, big corporates are also repatriating billions of cash parked overseas, a good portion of which has gone to finance share buybacks (thereby boosting earnings per share).
There will be some tailwind from tax reform, deregulation, low unemployment, improving productivity and robust consumer confidence. The latest employment data showed signs of stronger wage growth as unemployment remains at a low 3.9%.
US corporates should continue to see double-digit clip of earnings growth in 2H2018, although perhaps slightly slower than the blistering pace in 1H2018. Analysts forecast roughly 20% y-y growth for 3Q2018. This would lower the forward PE for the S&P 500 to around 17-18 times.
For comparison, the index traded between 11 and 26 times and averaged 17.8 times in the past 16 years (2002-2018). If we were to go back even further, PE ranged from 12-30 times and averaged 19 times between 1988 and 2018. Therefore, whilst prevailing prices are not cheap, they do not appear overly expensive either.
Looking beyond 2018, corporate earnings growth is currently expected to moderate to around the mid to high single digit clip, without tax boost. This means that future gains for the S&P 500 would likely be more modest, if valuations are to remain steady.
One could even argue that PE for the S&P 500 should be higher compared with historical averages – due to the increasing influence of higher growth technology stocks. Over the longer-term, their prospective growth will almost certainly exceed those for non-techs such as consumer staples, discretionary and traditional retail, utilities, financials, etc.
Looking at valuations from yet another perspective, bonds compete with stocks for investment dollars. Therefore, we could also compare the yields (returns) from both to determine their relative attractiveness.
The forward earnings yield (which is the inverse of PE multiple, estimated at 18 times) for the S&P 500 is roughly 5.5%. The 10-year US bond yield is hovering just under 3%. From a historical point of view, whilst the equity-bond yield gap has narrowed from five years ago, it is still fairly decent at over 2.5% currently. (See Chart 5)
Chart 5: US equity and bond yields over the years
Bond yields have been anaemic for years because of low inflationary expectations – due to tepid wage growth, digitalisation, globalisation, etc. – and may well stay low going forward given the added disinflationary effect of a strong greenback.
At some point though, the current expansion would come to an end, as dictated by economic cycles – we just don’t know when or why. It could be because of escalation in trade conflict and tariffs or unsustainable debt levels or other events currently unforeseeable.
Table 1: Historical PE range for S&P 500 (2002-2018)
Meanwhile, valuations for the rest of the world have fallen. Chart 6 shows that most Asian markets are now trading at lower valuations compared to US stocks. PE for the MSCI Asian index has fallen below its 10-year average, though still higher than recent crisis valuations (see Chart 7).
US stocks are being driven higher by strong earnings growth and liquidity inflow. The opposite is true for the rest of the world. In other words, lower PE markets may not really be ‘cheaper’ relative to their prospective growth.
It is worth noting that there are few significant tech players outside of China (and those listed in Hong Kong). Hence, bellwether indices for most of these markets mostly consist of stocks from financial services, commodity, telecommunication, consumer and manufacturing sectors – traditionally lower growth companies.
Asian markets also face rising risks – and likely corporate earnings downgrade. Perhaps not so much in terms of contagion from brewing crisis in Turkey and Argentina – which are precipitated by domestic events – but certainly from US tightening and trade conflict.
Emerging markets have been the biggest beneficiaries of unprecedented quantitative easing by the US Federal Reserve. For nearly a decade, the surge in cheap money spilled over into these markets in search of higher yields, lifting asset prices and financing growth through debt. These countries will now suffer the reverse.
The Fed has started shrinking its balance sheet – the amount will rise to about US$50 billion a month come October – and raising benchmark interest rates at a steady pace, underpinned by its robust economy. Furthermore, widening fiscal deficit means the government will need to borrow more money going forward.
In short, liquidity will continue to tighten and capital will be drained from emerging markets and flow back into the US. Some countries, including Indonesia, Philippines and India, are being forced to hike rates in tandem with the Fed, to support their currencies.
The European Central Bank is also poised to end its quantitative easing programme by end-2018.
The combined global liquidity contraction will damp growth at a time when the world’s economy is already slowing and under further threat from trade tensions. All these may well, eventually, filter back into the US economy (as well as that of other developed nations). Remember, Asia and especially China account for a material percentage of the global economy and growth.
At some point, the divergence between US stocks and the rest of the world will hit an inflection. But for the moment, the US is the beneficiary of the unfolding turmoil in emerging markets, while the latter undergo painful adjustments to the new environment.
Performance Comparison Since Inception (%)
%-258.9-10-505101520253035404550556065
- Tong's Value Investing Portfolio
- FBM KLCI
| SHARES HELD | QUANTITY | AVERAGE COST | COST OF INVESTMENT | CURRENT PRICE | CURRENT VALUE | GAIN / (LOSS) | GAIN / (LOSS) |
|---|---|---|---|---|---|---|---|
| SCGM BHD | 11,066 | 1.742 | 19,273.7 | 1.350 | 14,939.1 | (4,334.6) | (22.5%) |
| AJINOMOTO (M) BHD | 1,500 | 11.813 | 17,720.0 | 21.960 | 32,940.0 | 15,220.0 | 85.9% |
| PANASONIC MANUFACTURING MSIA | 600 | 26.307 | 17,182.0 | 39.000 | 23,400.0 | 6,218.0 | 36.2% |
| Y.S.P.SOUTHEAST ASIA HOLDING | 10,500 | 2.413 | 25,340.0 | 2.980 | 31,290.0 | 5,950.0 | 23.5% |
| FORMOSA PROSONIC INDUSTRIES | 18,000 | 1.540 | 27,720.0 | 1.390 | 25,020.0 | (2,700.0) | (9.7%) |
| HONG LEONG INDUSTRIES BHD | 2,000 | 9.276 | 18,551.0 | 10.580 | 21,160.0 | 2,609.0 | 14.1% |
| WILLOWGLEN MSC BHD | 19,900 | 0.500 | 9,950.0 | 0.450 | 8,955.0 | (995.0) | (10.0%) |
| MALAYAN BANKING BHD | 3,000 | 10.500 | 31,500.0 | 9.880 | 29,640.0 | (1,860.0) | (5.9%) |
| MAH SING GROUP BHD | 19,000 | 1.010 | 19,190.0 | 1.040 | 19,760.0 | 570.0 | 3.0% |
| ECO WORLD DEVELOPMENT GROUP BERHAD | 15,200 | 1.235 | 18,772.0 | 1.190 | 18,088.0 | (684.0) | (3.6%) |
| DIALOG GROUP BHD | 5,700 | 3.470 | 19,779.0 | 3.460 | 19,722.0 | (57.0) | (0.3%) |
| GENTING MALAYSIA BERHAD | 3,800 | 5.130 | 19,494.0 | 4.930 | 18,734.0 | (760.0) | (3.9%) |
| TOP GLOVE CORPORATION BHD | 1,800 | 11.000 | 19,800.0 | 10.500 | 18,900.0 | (900.0) | (4.5%) |
| Total | 264,271.7 | 282,548.1 | 18,276.4 | 6.9% | |||
| Shares bought | |||||||
| No transaction. | |||||||
| Total shares held | 264,271.7 | 282,548.1 | 18,276.4 | 6.9% | |||
| Shares sold | |||||||
| No transaction. | |||||||
| Cash Balance | 35,234.6 | ||||||
| Realised Profits / (Losses) | 99,506.3 | ||||||
| Change since last update Sep 6, 2018 | |||||||
| Portfolio | (1.1%) | ||||||
| FBMKLCI | (0.3%) | ||||||
| Portfolio Returns Since Inception | 200,000.00 | 317,782.7 | 117,782.7 | 58.9% | |||
| Portfolio Returns (Annualised) | 15.0% | ||||||
| Portfolio Beta | 0.637 | ||||||
| Risk Adjusted Returns Since Inception | 92.5% | ||||||
| Performance Comparison | At Portfolio Start | Current | Change | Relative Portfolio Outperformance | |||
| FBM KLCI | 1,829.7 | 1,792.6 | (2.0%) | 60.9% | |||
| FBM Emas | 12,700.4 | 12,423.6 | (2.2%) | 61.1% | |||
Footnote:
*Current price is as at September 13, 2018.
*Portfolio started on Oct 10, 2014 with MYR200,000.
*This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks.
*Current price is as at September 13, 2018.
*Portfolio started on Oct 10, 2014 with MYR200,000.
*This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks.
STOCKS SOLD IN THE LAST 12 MONTHS (Currency: MYR)
| SHARES SOLD | DATE BOUGHT | DATE SOLD | QUANTITY | AVERAGE COST | COST OF INVESTMENT | PRICE SOLD | SALES PROCEEDS | GAIN / (LOSS) | GAIN / (LOSS) |
|---|---|---|---|---|---|---|---|---|---|
| CLASSIC SCENIC BHD | 26-Jan-16 | 13-Jul-17 | 4,000 | 1.413 | 5,651.3 | 1.815 | 7,260.0 | 1,608.8 | 28.5% |
| MIKRO MSC BERHAD | 01-Dec-16 | 27-Jul-17 | 42,000 | 0.331 | 13,920.0 | 0.545 | 22,890.0 | 8,970.0 | 64.4% |
| CLASSIC SCENIC BHD | 01-Dec-16 | 27-Jul-17 | 4,000 | 1.413 | 5,651.3 | 1.790 | 7,160.0 | 1,508.8 | 26.7% |
| PANASONIC MANUFACTURING MSIA | 21-Jan-16 | 27-Jul-17 | 400 | 26.125 | 10,450.0 | 37.100 | 14,840.0 | 4,390.0 | 42.0% |
| ELSOFT RESEARCH BHD | 30-Mar-17 | 24-Aug-17 | 8,000 | 1.844 | 14,750.0 | 2.650 | 21,200.0 | 6,450.0 | 43.7% |
| JOHORE TIN BERHAD - WA 12/17 | 04-May-17 | 24-Aug-17 | 17,000 | 0.655 | 11,135.0 | 0.680 | 11,560.0 | 425.0 | 3.8% |
| FOCUS LUMBER BERHAD | 03-May-17 | 30-Aug-17 | 6,000 | 1.660 | 9,960.0 | 1.530 | 9,180.0 | (780.0) | (7.8%) |
| WILLOWGLEN MSC BHD | 23-Nov-16 | 30-Aug-17 | 7,000 | 0.768 | 5,377.0 | 1.430 | 10,010.0 | 4,633.0 | 86.2% |
| WILLOWGLEN MSC BHD | 23-Nov-16 | 28-Sep-17 | 7,000 | 0.770 | 5,377.0 | 1.180 | 8,260.0 | 2,883.0 | 53.6% |
| LII HEN INDUSTRIES BHD | 14-Dec-16 | 28-Sep-17 | 5,000 | 2.820 | 14,100.0 | 3.720 | 18,600.0 | 4,500.0 | 31.9% |
| COMFORT GLOVES BERHAD | 28-Aug-17 | 08-Dec-17 | 25,000 | 0.960 | 24,000.0 | 0.930 | 23,250.0 | (750.0) | (3.1%) |
| JOHORE TIN BHD | 08-May-17 | 08-Dec-17 | 9,000 | 1.600 | 14,400.0 | 1.180 | 10,620.0 | (3,780.0) | (26.3%) |
| THONG GUAN INDUSTRIES BHD | 12-Dec-16 | 08-Dec-17 | 5,000 | 4.243 | 21,215.0 | 4.100 | 20,500.0 | (715.0) | (3.4%) |
| KERJAYA PROSPEK GROUP BERHAD | 12-Jan-17 | 15-Mar-18 | 11,000 | 1.025 | 11,280.0 | 1.540 | 16,940.0 | 5,660.0 | 50.2% |
| KERJAYA PROSPEK GROUP BERHAD - WARRANTS B 2018/2023 | 08-Mar-18 | 15-Mar-18 | 3,000 | 0.000 | 0.0 | 0.330 | 990.0 | 990.0 | - |
| LUXCHEM CORPORATION BHD | 30-Aug-17 | 15-Mar-18 | 16,500 | 0.732 | 12,072.5 | 0.720 | 11,880.0 | (192.5) | (1.6%) |
| WILLOWGLEN MSC BHD | 14-Dec-17 | 22-Mar-18 | 20,000 | 1.010 | 20,200.0 | 1.260 | 25,200.0 | 5,000.0 | 24.8% |
| MUAR BAN LEE GROUP BERHAD | 26-Oct-17 | 22-Mar-18 | 13,500 | 1.240 | 16,740.0 | 1.170 | 15,795.0 | (945.0) | (5.6%) |
| CHOO BEE METAL INDUSTRIES BHD | 07-Sep-17 | 16-May-18 | 8,000 | 2.190 | 17,520.0 | 2.440 | 19,520.0 | 2,000.0 | 11.4% |
| CHOO BEE METAL INDUSTRIES BHD | 07-Sep-17 | 21-May-18 | 8,000 | 2.190 | 17,520.0 | 2.300 | 18,400.0 | 880.0 | 5.0% |
| SUPERLON HOLDINGS BHD | 01-Dec-17 | 21-May-18 | 6,000 | 1.175 | 7,050.0 | 1.550 | 9,300.0 | 2,250.0 | 31.9% |
| OKA CORPORATION BHD | 14-Dec-17 | 28-Jun-18 | 12,000 | 1.541 | 18,488.0 | 1.270 | 15,240.0 | (3,248.0) | (17.6%) |
| SUPERLON HOLDINGS BHD | 01-Dec-17 | 28-Jun-18 | 6,000 | 1.175 | 7,050.0 | 1.210 | 7,260.0 | 210.0 | 3.0% |
| WILLOWGLEN MSC BHD | 14-Dec-17 | 28-Jun-18 | 100 | 0.500 | 50.0 | 0.540 | 54.0 | 4.0 | 8.0% |
| PANTECH GROUP HOLDINGS BHD | 17-May-18 | 02-Aug-18 | 43,000 | 0.580 | 24,940.0 | 0.560 | 24,080.0 | (860.0) | (3.4%) |
A Note to Readers
It is my pleasure to share with you my Value Investing Portfolio. However, I must emphasize that it is by no means a recommendation or a solicitation or expression of views to influence you to buy or sell any stocks. I am just sharing openly on what I am doing with my stock portfolio.
Further, I like to remind all investors that investing is not just about the profits or returns. You will inevitably suffer stock losses too. You need to understand your own investment objective, risk appetite and the amount of loss you can afford to bear. So, while many investors talk only about absolute returns, I am also sharing the computed risk-weighted returns of my portfolio.
Tong Kooi Ong
