Overvaluation: A Quaint Reason To Sell
It should be no surprise that worldwide stock markets are in orbit. In the era of zero—and now even negative-interest—rates, today’s system lacks an obvious anchor. With due respect to Messrs. Buffett and Graham, bottom-up valuation analysis has almost become an anachronism. Of course, its predictive abilities will surely surface again, but, for now, macro factors are driving capital markets.
This is why persistent calls for U.S. underperformance based on overvaluation (the S&P 500 trades on a Shiller CAPE of 27.9 versus its 30-year average of 23.5) have been—to put the most charitable spin on it—early.
Where, then, should investors focus? Consider three key drivers—all of which point to U.S. equity outperformance heading into reverse:
Global Currency War: America Losing
A notable feature since 2008 has been the emergence of far more aggressive currency management by governments, classically referred to as "competitive devaluation." The reasoning is straightforward: capturing external demand is critical when domestic spending is constrained by weak income growth. Policymakers fully understand this (whether they admit it or not).
In the ongoing competition, it has been key to own equities in economies that have already successfully devalued their currency or currency-hedged equities in countries that are on an aggressive currency devaluation path. We have written extensively on this and positioned portfolios accordingly.
Since 2008, U.S. equities have been a clear winner. That makes sense. The U.S. dollar spent most of the 2000s on a debasement path and the domestic economy emerged from the financial crisis extremely competitive.
All that is now changing. The U.S. dollar has rallied hard, up more than 18 percent for the euro and 10 percent for the yen in the last six months. In a very short period, the U.S. dollar has gone from being significantly undervalued against almost all currencies, to being fairly valued against most, and overvalued against key pairs like the euro and the yen.
Head Winds On The Horizon
Unsurprisingly, those effects are now starting to bite, and stiff head winds are emerging. As the last few companies report Q4 2014 results, S&P 500 operating earnings per share are projected to come in 5.2 percent lower than Q4 2013, the largest year-over-year decrease in more than five years.
Admittedly, the energy sector weighed heavily on earnings, but with approximately 46 percent of S&P 500 revenues generated abroad, currency translation losses and weakening export competitiveness should not be understated. FiREapps estimated that North American companies incurred more than $18.6 billion in currency losses in Q4 alone, which is higher than the previous five quarters combined.
Given that the effects from a strong U.S. dollar are unlikely to quickly abate, U.S. equity bulls must pin their hopes on a massive boom in domestic earnings. To be sure, that is not an unrealistic scenario. Private sector gross domestic product has been growing at a steady 3 percent to 3.5 percent for the past four years.
But why not play the U.S. consumer by buying European or Asian exporters, regions that have radically sharpened their competitiveness through currency debasement, benefit more from a lower oil price and, if one insists on measuring valuation, trade on much cheaper multiples?