After a jittery January, investors in US equities are gritting their teeth. But even if equities lose some steam after last year’s rally, we think company fundamentals and the interest-rate environment should support a resilient market in 2015.
At first glance, US equities look expensive. The S&P 500 Index traded at a price/forward earnings ratio of 16.3 at the end of 2014—63% higher than at the market trough in 2009. US stock valuations are much higher than those of their emerging- and developed-market peers. And the S&P 500 has only been more expensive than today in about 15% of all quarters since 1970.
Paying More for Healthier Companies
But has the market really risen too far? Valuations might be higher than usual, but the market is also much healthier than usual. Compare today with the October 2007 peak. US companies are generating substantially more cash and have reduced debt dramatically while profitability is similar (Display). Fundamentals for international companies aren’t nearly as good. So US stocks might be a bit more expensive than normal, but we think investors are getting much more for their money—in both a historical and global context.
High profitability looks sustainable, in our view. Profit margins of nonfinancial S&P companies—and especially manufacturers—have risen sharply in recent years because of structural changes driven by globalization, outsourcing and process reengineering (Display). Outside of the energy sector where consensus expectations are rapidly catching up with the fall in oil prices, none of these things is going away soon. And for some sectors of the market—especially consumer industries—lower energy prices will be a boost to earnings.
We also think that interest rates will probably stay lower for longer, as low oil prices suppress inflation. This is good for earnings, too. Financing expenses account for about 1.5% of US company sales today—down from 1.7% in 2010 and almost a third lower than the 2002 peak.
What’s more, many companies have locked in low rates on their extended maturities, which should help mute the future impact of rising rates on profit margins. Low inflation and solid economic growth also make a great recipe for companies to sustain sales growth.
Low Rates Support Higher Valuations
Today’s above-average valuations make sense when interest rates are low. A low discount rate means that future cash flows are worth more, and investors will be willing to pay more for them today. Against this backdrop, we think relatively high US equity valuations don’t seem quite so scary.
Of course, the US market will face plenty of challenges and uncertainties. The principal risk is global economic growth. Many investors are worried that the declines in long-term interest rates, inflation expectations and commodity prices are the result of weak demand rather than excess supply of commodities and capital. While there is evidence of slower growth in Europe and in emerging markets, US economic data, for the time being, have remained robust. So for now, we don’t think these risks portend a major pullback in US stock prices.
Beware of Cash Hoarders
For investors, what really matters is how companies behave. In today’s environment, we believe companies will have to think twice about hoarding their cash. Companies with attractive valuations of free cash flow are especially appealing, as an acceleration of economic growth could prompt a fresh wave of M&A activity and provide an impetus for more share buybacks.
Investors might also look at income-oriented, slower-growing stocks, which should do well in a prolonged low-interest-rate environment. Among income-oriented stocks, we prefer those with high free-cash-flow yields to high dividend yields: they’re cheaper and have the option of raising payouts or investing for growth. More broadly, we see a big opportunity today for stock pickers: when the US market as a whole is relatively pricey, active managers can add value by targeting companies with relatively low valuations and stronger fundamentals than their peers.
This blog was originally published in InstitutionalInvestor.com
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.