'Mind your Eye' the US looks (too) high

Monday, 3rd July 2017 09:33 - by David Harbage

It is three weeks since this blog last commented on the uncertainty facing owners of UK equity, concluding that ‘investors in domestic stocks (especially consumer-sensitive businesses) should revisit the confidence they have in the fundamentals and valuations of each business post this election non-result’.     

While close examination often provides the best assessment, the noise and hectic pace of daily events – in life or in financial markets - can be unhelpful when trying to make sense of a particular issue or solve a problem. Having flown almost twelve hours from the world’s prime financial capital, and adopted a more relaxed global view over the past couple of weeks, the writer would concur with those who believe that this long distance - perhaps ‘top down’ -perspective on macro-economic matters is likely to facilitate sound judgement. 

The most recent data and news flow, as well as forward-looking survey evidence, has suggested that much of the world’s economy is performing well and on an upward path; with pronouncements from central bankers and economists pointing to 2017 as marking the end of the deflation trade and the nadir in the interest rate cycle. In the early stages of a typical textbook economic recovery, companies are natural beneficiaries of both top-line revenue and bottom-line earnings. It is only as capital expenditure is ‘ratchet up’, to increase production or capacity to meet higher demand, that profitability is squeezed.

However, in the UK a different picture may be emerging. Here is an economy featuring high levels of employment, but the labour force’s share of the country’s created wealth has diminished (most obvious when considering take-home pay of 90% of the population). Consumer confidence is critical in ensuring that the economic machinery functions. Clearly one of the messages proclaimed by the electorate on June 8 is a cry for change. Living standards have fallen, evidenced by a sharp drop in disposal income alongside today’s feature of an exceptionally low savings rate (1.7% of disposable income is saved, the lowest level since records began in 1963). 

A near-absence of wage growth and higher, sterling weakness-induced (imported) food costs have squeezed incomes and only been partially alleviated by higher borrowing. Therefore, that economic growth slowed to 0.2% in the first quarter of 2017 (from 0.6% in the final three months of 2016) should not surprise. The prospect of the Conservative government (supported by the DUP) considering an easing in its policy of being tough on public finances - evidenced by debate surrounding the lifting of the 1% cap on public sector pay – makes for interesting viewing. Certainly a resultant pick-up in inflation will reinforce calls for higher interest rates at home, if only as a pre-emptive warning to those tempted to use the credit card as a means of circumventing (if only temporarily) flat economic conditions.

Minutes of the last meeting of the politically-independent Monetary Policy Committee of the Bank of England showed that 3 of the 9 entitled to vote, and decide, the UK’s Bank or base rate wanted to begin the hiking process. But before savers begin to rejoice that interest rates are beginning to move in their favour, they should appreciate that the domestic economy is unlikely to cope with a single digit rate (in excess of 1%) before 2019. Sterling has firmed to US$1.30 in anticipation of higher UK rates, but the greater probability is that both economic growth and interest rates in the United States will outpace us.  

Besides the indecisive result of the election itself, the conflicting noise emanating from our politicians over the past month or so (on policy and on prospective leadership) will not have aided confidence for domestic consumers, encouraged business investment or stimulated overseas investors into UK plc. However, adopting a polarised view of ‘global is strong’ and ‘domestic is weak’, and making company share selections on that basis, would be to ignore the respective ‘stretched’ and ‘depressed’ valuation of multinationals or domestically focused businesses.

The price at which leading US listed companies – notably technology giants like Apple or web-related firms such as Amazon - are exchanging hands is, in this writer’s humble opinion, extreme. Moreover, with so many more similarly highly priced businesses capturing attention, with less obvious claims of sustainable profitable greatness, this has led many commentators to liken today’s conditions in valuing American equities (typically assessing and discounting 20 year+ profit streams) to those which prevailed in the US and the UK at the turn of the Millennium in the telecom/media/technology (TMT) sectors. It would seem inevitable that any material disappointment from one of the US technology majors could result in a sharp fall and prompt a wider retreat in stock prices across Wall Street.

To be clear, the US economy appears to be in good shape and poised to make reasonable progress over the next couple of years, but many listed stocks have motored too far ‘ahead of events’ – in part carried away by unrealistic expectations about what the new Administration can deliver. A correction on Wall Street seems more probable than possible and, for investors in UK shares, the prime question would seem to surround the extent to which our company stocks are marked down. As you may notice, this writer prefers to use words like ‘correction and ‘mark down’ are used rather than the more emotive, headline ‘crash’ or ‘collapse’ – given that every previous fall in the UK or US stock market (best measured by indices such as the FTSE100 or S&P500, respectively) has only been succeeded by the achievement of higher levels.

What should the cautious private investor be doing in such circumstances?

Most investors are naturally attracted to taking a stake or owning real businesses by the prospect of sharing in the profits (via dividends) and appreciation in capital (as a firm’s assets, such as its property, may become more valuable). Selection is usually based on a belief that a particular business activity or sector of industry has merit (either offering the prospect of growth or at least resilience). The sensible ideal is that the private investor understands the company’s business model and invests across a wide spectrum of commerce, if not the whole market. However, beyond these fundamentals, the need to focus on the valuation or price of individual company shares (or a diversified basket, such as the FTSE100 index), relative to the alternatives on offer - be it another equity market, such as the United States or continental Europe - cannot be over-emphasised. 

In the case of the UK equity market, there appears to be a sensible valuation – by contrast with US stocks, cash returns and bond yields – but that doesn’t mean that London-listed company shares wont retreat if Wall Street turns lower. Moreover, within the overall FTSE100 index there is quite a sharp (greater than usual) dispersion between highly valued and more lowly rated businesses. Again, even apparently undervalued stocks will be marked lower in a significant sell-off. Most importantly in such circumstances, investors should remind themselves of their intended timescale and inevitable volatility of such investment before pressing the panic button.

Incidentally, speaking of volatile share prices - which can be an indicator of markets’ valuation (volatility rises when a market is perceived to be close to a low or high point in a particular cycle) – volatility is currently surprisingly low. Volatility indices (the United States’ VIX is the most widely used one in respect of company shares) measures the market’s expectations of future volatility (movement in share prices), based on the price of stock exchange listed financial instruments known as options.  These indices, which are calculated on an annualised basis and expressed in percentage terms, are key barometers of investor sentiment. When equity indices are high, have consistently risen over a long period of time and earnings-based valuations appear stretched compared to history, one would expect volatility to rise (as the scope for a significant move downwards increases).

However although the leading indicator of the valuation of US company stocks – the Standard & Poor’s (or S&P) 500 index – has been strong in 2017, the VIX index has been exceptionally low. Currently at 11%, but this index reached a 20 year low of 7% last month; this compares to a 20 year average in the low teens and previous instances of sparks up to 50%. On the face of that evidence, US investors do not seem to be worried by the high valuation of their equity market – perhaps more distant viewers can see more? 

As regular readers of this blog will know, we continue to encourage close inspection of brokers’ forecasts of future profits as a means of being reassured by the valuation of stock exchange listed company shares. The most recent earnings revisions (published in the forms of indices by the likes of Reuters) show that, since the beginning of 2017, continental European companies have seen a 2% hike in immediately forecast profits, but the UK and the US have slipped by 1% and 1.5% respectively. Over a twelve month period, profit projections on UK equities have progressed well – but the sterling-weakness induced tailwind of the second half of 2016 now appears to be in the past. 

Taking a look at individual companies may produce very different results to the wider market landscape. For instance, it might be appropriate to briefly comment on our blog’s two ‘Stocks for 2017’ at this, the half way stage of the year. New home constructor Bellway announced a trading update a fortnight ago, covering the period from 1 February to 4 June, which prompted analysts at 14 research houses to upwardly revise their profit forecasts. In our 3 January blog, we highlighted brokers’ consensus earnings forecast for the company’s trading year to 31 July 2017, which was 329.3p per share; six months later that forecast has moved to 355.2p, with 380.6p currently predicted for the following year to July 2018. The shares have reflected these rising expectations in earnings per share (EPS) by advancing 20%, from 2473p to 2975p.

Our other, higher risk-reward ‘Stock for 2017’ the online payments business Paysafe Group, issued an interim management statement last month covering the first three months of the year, which boasted strong growth but indicated a slowing in the exceptional pace of previous periods. As a consequence the 38p EPS forecast for 2017 at the beginning of the year has been reduced to 36.2p (in itself a startling 59% jump). However, investor enthusiasm for this, another FTSE250 index constituent, has not waned and the shares have risen 36% in the first half of 2017, from 373p to 511p.

The forward-looking price-to-earnings comparator (or PE ratio) for Bellway was 7.4 times at the beginning of 2017 but, with the share price slightly exceeding the pace of the previously mentioned earnings revisions, the PE ratio for the shares remains at 7.9 times. This blog never makes recommendations (of course), but the low earnings multiple continues to make the national volume builder’s stock look anomalously attractive against the wider market’s valuation.

By contrast, the shares of Paysafe Group look fairly, if not fully, priced as the rise in the stock - combined with the reduction in profit forecasts – have taken the PE ratio from an apparently cheap 9.9x calendar 2017’s forecast EPS six months ago to an earnings multiple of 12.8 times today. Having said that, the seven brokers that monitor the firm anticipate a 10% advance in profits in 2018, so the growth story does not appear to have ended just yet – but perhaps the shares now appear ‘up with events’ for the time being.   

For your interest, applying the same forward (looking out one year ahead) earnings multiple to the wider UK equity market, this has barely changed over the past six months: from 13.5x to 13.9 times anticipated profits, as the FTSE100 rose 2.2% in the first half of 2017 while EPS expectations fell 1%. 

Finally, taking a look at the two company shares again, and in particular their most recent trading and valuation, it can be seen that investors may adopt different views – perhaps by reference to the time horizon, strategy (be they shorter term traders or longer term investors), and appetite for risk (with no dividend pay-out from Paysafe Group, compared to Bellway’s above market average income yield) amongst other factors. Investors who fear a US-driven storm could adversely impact the worth of their equity investments may be seeking lower risk and priced assets – perhaps including property backed company shares and businesses providing essential (rather than discretionary) products.