Is it time to switch out of US equities?
We’ve been closely watching the US market. And we believe now is the time to reduce our investment exposure. It’s time to switch out of US shares and into more attractively priced markets like Australia and Japan.
Reducing our exposure
This is not a knee-jerk reaction to recent volatility. We’re constantly analysing and watching international trends.
The story out of the US over the past few years has been one of strong growth in equities. In fact, US shares have been performing almost too well.
The recent market turmoil may prove to be the nail in the coffin of this run. And we don’t think it will stop anytime soon.
We’re expecting the US to fall further and recover less than other markets in the coming years. Which means substantial underperformance and very low returns on US shares for the next decade.
Protecting your wealth
All markets dropped as a result of the US fall. But Australian shares and other international markets are still far more attractively priced. So it’s a good time to migrate out of US shares.
We’re taking a proactive position. And, as always, our aim is to maximise investment opportunities for our clients. After all, it’s your future wealth we’re protecting.
We believe the US market will continue to be volatile without delivering significant returns. And if we’re not likely to be rewarded for risk, why take it?
Let’s take a closer look
There’s no denying the US has been the best performing market in the world over the past five years. You can see in Figure 1 below, that it returned 22.5% pa.
Figure 1: World share market returns (2012-2017)
Dec 2012 -Dec 2017
|Asia Pacific Ex Japan||13.6% pa|
|Source: FTSE, RBA|
But as the great Warren Buffett said, “if returns came out of history books, librarians would be the richest folks around”.
In other words, history is no indication of where we’re headed. But the detail beneath the headline is worth looking at. The true long-term drivers of market performance are dividends and earnings growth. And these two produced just 6.5% of the total returns of 22.2%pa.
So let’s take a closer look at earnings growth. Over the past 20 years earnings growth for US shares has been around 5.0%pa. Moving forward, we think growth of around 3.7% pa is realistic. This is because of the current low inflation environment and high profit margins.
And because we are paying way too much for shares, dividends are low, at around 1.8%. The higher the price we pay for a stock, the lower the dividend.
When we add these two drivers together, we’re looking at a return of around 5.5%pa. Not too bad, we hear you say.
What’s driving the market?
But there’s more. Market sentiment has been a tailwind driving the US market up.
The change in PE ratio, improving sentiment, has doubled the total returns from US equities over the past five years.
But we see it becoming a headwind over the next decade.
This will take the shine off long term returns, by about 2.3%pa and reduce our likely returns down to 3.3%pa.
A weaker Australian dollar will help. But it’s not enough to save the day.
Why risk it?
So, we end up with an expected return that is no better than what you’d make if your money was in a term deposit. This is our definition of an overpriced market. And if we are not likely to be rewarded for the risk, why take it?
We prefer to look at other share markets instead. Europe, Japan and Asia are currently much more attractive.
|Figure 2: Forecast World equity returns|
|US||Europe||Japan||Asia Ex Japan|
|Expected 10 yr return||3.3%pa||9.3%pa||8.2%pa||8.5%pa|
|Current PE ratio||23.8||19.0||16.9||16.2|
|Source:FTSE All World Indices, S&P, farrelly’s analysis|
Is there more to come?
We’re not counting on history repeating….
…and we’re not in the business of crystal ball predictions.
We don’t know for sure if the US market will continue to fall or resume its rise over the coming year.
But we do know it will very likely turn downward again at some point in the next 3 to 4 years.
And when it does, the longer it has been above fair value the greater will be the drop.
So what are we doing about it?
It’s a fair question! We are responding. We’ve found the optimal strategy for dealing with expensive markets in the past has been to take profits slowly. Our exposure to US equities is mainly through managed funds. It’s important we understand each fund, how they invest and what their exposure is to overpriced equities. We are analysing and assessing our clients’ exposure now. This will feature in each client’s next review with the aim of gradually taking profits over the coming 18 months.