Valuation potholes mar US road to recovery

Despite better news on the economy and widespread expectations of a pivot in monetary policy in the coming quarters, investors in US equities should tread with care in the months ahead and be cognisant of valuations, according to two market experts.

“The market is pricing in two rate cuts in the back half of this year, and I don’t believe it,” says Abrdn’s Fran Radano (pictured), manager of the North American Income Trust (Nait). “Monetary policy works with a lag, but the Fed started the hiking cycle six months too late and won’t risk cutting rates too early.”

Eric Papesh, a US equity portfolio specialist at T Rowe Price, agrees that the US central bank is “in a difficult spot”, given its dual focus on price stability and the labour market. “Our base case is a slower pace of tightening, but rate rises of 25 or 50 basis points would still mean rates are higher than currently. The Fed has hiked meaningfully in the last 12 months, and it is only a matter of time before that hits the real economy in terms of sales, margins and earnings.”

Both Papesh and Radano feel the rally in the US equity market so far in 2023 may be founded on false optimism. “The S&P 500 is currently over 4000 and is not pricing in a recession at these levels,” says Radano. With a consensus earnings estimate of $225, he explains the index forward P/E valuation is currently 18x, but a more realistic earnings number of $200—a figure also quoted by Papesh—would see that multiple increase to 20x.

“And a 20x P/E with the Fed Funds rate approaching 5% seems overvalued in aggregate,” he says.

Bifurcated market

Radano’s income remit naturally leads him to avoid some of the US market’s most highly valued sectors, which – with the exception of the past year – have largely driven index returns in the post-global financial crisis period.

“When the cost of capital is no longer negative, valuations, profits and cash flows start to matter,” he says, pointing out that the market remains bifurcated, with growth stocks on P/E multiples of 22-23x while value stocks are more like 15x, and the Nait portfolio average forward P/E is 13x given the manager’s relatively defensive positioning.

“We are not uber-bears hiding in telecoms and utilities; we are keeping a diversified portfolio but staying away from more cyclical, higher-beta names,” Radano explains. The portfolio average dividend yield is north of 3.5% with dividend growth in the mid-to-high single digits, which the manager says gives a good cushion and a margin of safety in an environment where dividends are expected to make up a greater proportion of total returns.

“Historically, dividends have made up anything from a third to a half of total returns, but in the past 10 years it has been 10-15%, and we would look for that to be a bit more going forward.” Nait’s largest sector weightings are currently in financials, healthcare and energy, with relatively low exposure in consumer names.

Although T Rowe Price is known as a growth investor, around one-third of its US equity assets are in core and value strategies, which are Papesh’s area of focus. He says the portfolios he works on are “more defensively tilted at the margin”, having reduced cyclicality early in 2022 – a strategy that worked out favourably, given the market volatility.

However, he argues that the timing of this move was of the essence: “Now is not the time to be going defensive; that was nine or 12 months ago.”

Instead, he is leaning in to sectors that have been “in the crosshairs of controversy” and where valuations are now more compelling, seeking opportunities in areas such as consumer, tech and industrial stocks, although only where balance sheets, management and business execution is strong.

Examples of stocks with long-term upside but where valuations reflect near-term challenges include Stanley Black & Decker – an industrial name with significant consumer exposure through its DIY tools; electronics retailer Best Buy; and computer storage name Western Digital.

Abundance of yellow flags

Looking ahead, Papesh says his goal is to have “a balanced portfolio without huge directional bets on recession versus soft landing”, given the continued debate over the state of the US economy.

Radano is a little more cautious: “A soft landing is an enticing prospect, but banking on the Fed to thread the needle [of controlling inflation while not inducing a recession] is difficult to envision. We don’t need to see ‘blood on the streets’ as Sir John Templeton said, but if employment unwinds a little then consumer spending will go down, and the consumer is 65-70% of GDP – there are a lot of yellow flags.”

While Peter Hargreaves, chair of the technology-tilted asset manager Blue Whale, recently counselled UK-based investors to address their underweight to the US, saying “it seems sensible to seek the large successful companies in the safest economy”, for these two US equity specialists at least, a more considered, valuation-aware and stock-specific approach could be the key to winning in the world’s largest stock market.