Will the S&P 500 march on?

The S&P 500 is hovering just below the 2,000 all-time high it struck earlier this week, but by no means is it overvalued, experts argue.

Although Capital Economics thinks the market’s ascendency has, for now, reached its peak.

JP Morgan Asset Management chief global strategist David Kelly says it is a “consistent theme” among investors that the American market is too highly priced.

But several well-worn valuation methods show that is not the case, he says. “When we look at widely-used valuation metrics this just doesn’t seem to be the case,” Kelly adds. 

At July’s end, the S&P 500 Index was selling on a forward price/earnings ratio of 15.1, less than the quarter-century average of 15.6.

Also, the index’s prospective yield was running at 6.6 per cent – 1.8 per cent higher than that of Moody’s BAA bonds. The long-run average yield of the S&P is 70 basis points lower than the BAA yield.

“Some other measures, such as the Shiller P/E ratio or price/cashflow are running a little more expensive than average,” he concedes.

“However, a quick review of a range of market metrics suggests large-cap US stocks are at close to average valuations. But why does the stockmarket feel expensive even though, by the numbers, it isn’t?”

He believes the air of foreboding has been created by the “length and strength” of the market’s rally: It has climbed 185 per cent since hitting its floor in March 2009.

“Instinctively, this feels like too much of good thing,” he explains.

Fidelity Worldwide Investment chief investment officer Dominic Rossi remains bullish, despite the market’s rapid rise, corporate profits reaching record highs relative to GDP and imminent monetary normalisation.

The strength and duration of the rally will “surprise some investors”, he adds.

“Equity market volatility remains anchored and the outlook for the US economy is supported by a number of positive structural factors, including the shale boom and the improving budgetary position,” he explains.

“The earnings outlook also remains favourable and I think that those analysts that are arguing that US profits can’t go higher are very likely to be proved wrong.”

Capital Economics chief markets economist John Higgins thinks the S&P has essentially done its dash; its march is over.

“Although the S&P 500 has broken above 2,000 this week for the first time, we doubt that the stockmarket will go from strength to strength,” he argues.

“For now, we are sticking with our forecast that the index will end next year roughly where it is now.”

He bases that view on monetary normalisation – albeit slow and prolonged – that will be sooner and slightly more aggressive than widely expected.

Also, the price of debt is much higher than the price of equity, which leaves greater room for debt yields to rise with increasing interest rates without making the equity market appear expensive in relative terms.

“To be clear, we don’t expect the share [of corporate profits to GDP] to collapse. This is because it has received a structural boost since the turn of the century from globalisation, which has driven down labour’s share,” Higgins says.

“But we do think there is plenty of scope for a cyclical decline in the profit share as the labour market continues to strengthen, and as higher borrowing costs – triggered by less accommodative Fed policy – take some toll on increasingly-indebted US companies.”

Fed tightening will not deal “a fatal blow” to the stockmarket, but a monetary surprise could spark a temporary correction, he adds.

Hargreaves Lansdown senior analyst Laith Khalaf says opinion is divided over US prices, and he comes down in the slightly overvalued camp, both for earning and relative to other countries.

“However it is difficult to get too excited about other regions if you are negative about the US, given the impact it has on other markets,” he says.

“There are also enough doubtful voices in the market to suggest irrational exuberance is not wholly in the driving seat,” he adds.”