Money will flow to Europe, Japan - and the emerging markets, including India, notes Akash Prakash.
Stocks listed in the United States have been leading global markets ever since the current rally began in March 2009.
They have delivered approximately 150 per cent in absolute terms, compared to 80 per cent for non-US stocks.
Given their current valuations, the outlook for monetary conditions in the US and earnings trajectory, this period of out performance looks likely coming to an end.
When looking at expected future returns of any market one has to consider the outlook for earnings, dividends as well as multiples.
For both earnings and multiples there are clear challenges facing US financial markets.
On earnings, there are severe headwinds from both the oil price collapse and the dollar. Fourth-quarter earnings have been a disappointment and 2015 earnings estimates for the S&P 500 have been in freefall.
In January 2014, S&P500 earnings estimates for calendar 2015 were projected to be near $140. The same estimates today are at $120 (earnings for calendar 2015) and falling. This is the swiftest decline in earnings estimates since the financial crisis. The two main drivers of this decline are oil and the dollar.
Oil producers are overrepresented in the financial markets, accounting for eight per cent of market capitalisation, 11 per cent of market earnings, 33 per cent of capex and 16 per cent of all high-yield paper.
For the broader economy, however, energy firms account for only 3.3 per cent of profits, according to BCA Research.
Thus for the broader economy, lower oil prices will most likely be a net positive, with any decline in energy investment and profits more than offset by increased household consumption. However this same decline in oil prices is leading to an earnings cut for the S&P500, driven by the near 50 per cent reduction in energy sector EPS estimates.
We have a similar dynamic as far as the dollar and exports goes. Exports only account for 13 per cent of US GDP, but more than 30 per cent of S&P 500 revenues and nearly 40 per cent of profits.
Thus the continuing and relentless rise of the dollar will hit S&P 500 earnings far more than the real economy. The broad dollar Trade Weighted Index has appreciated by more than 14 per cent (since last June), enough to cut 2015 earnings by nearly four per cent.
While oil and the currency will dampen US earnings in the short term, the longer term constraint will be profit margins. As is well known, net profit margins for the US corporate sector are now over 10 per cent.
This is more than 50 per cent above the post-1960 average net margin of 6.3 per cent. While some of this margin improvement is because of a sectoral mix shift in S&P 500 earnings towards technology and healthcare (higher margin sectors) and thus sustainable, this accounts for only about 30 per cent of the margin rise, according to BCA.
The other big drivers of the margin have been falling interest costs and declining effective tax rates.
Neither of these two factors has much room to decline further. Eventually in a properly functioning capitalist system, we should see regression to the mean in both margins and real returns on equity or ROEs, both of which are at all-time highs.
If long term margins have peaked, even assuming no decline, then given subdued nominal GDP growth expectations it is difficult to see EPS growth in the US much above five per cent.
On valuations, whichever way you cut it, US equity markets are not cheap. Using the beloved Shiller P/E (price-earnings) ratio of the value investing crowd, the current reading of 27 is 34 per cent higher than the post-1960 median.
The current price/sales ratio is 73 per cent above the post-1960 median and on price/book ratios we are 37 per cent above the median. The median stock on the NYSE trades at a P/E ratio of near 22, even above the levels of the year 2000.
This reflects the fact that in 2000, the bubble was largely in the technology and internet space and some mega-caps, but large parts of the market were quite cheap. Today’s elevated valuations are far more widespread.
In addition to the earnings and valuation headwinds, financial conditions are tightening in the US. Interest rates are going up, most likely in 2015 itself, in stark contrast to the euro zone, Japan and most of the large EM economies.
The strengthening dollar will also act to tighten financial conditions. In recent years the Fed was the most aggressive liquidity provider in the world; it is now moving in exactly the opposite direction, which has to have an impact on financial assets.
Equity markets tend to stagnate if not turn negative when the Fed is in the midst of hiking rates. This is because even if earnings and economic growth are strong, valuation multiples normally contract during tightening periods.
How markets perform is basically contingent on whether earnings growth can be strong enough to overcome the multiple compression. Given our subdued outlook on earnings, outlined above, the markets will not be able to grow through the multiple compression brought upon by rising rates.
Given where valuations are today, it is also fair to assume that multiple compression will be significant.
Thus the outlook for US equities from here seems challenged. It is unlikely that the significant outperformance we have seen since 2009 will continue. Money will move to the euro zone and Japan. There is also the possibility of increased flow into the emerging-market asset class.
India is a consensus overweight among EM funds, and thus we have to always worry about flows into EM equities as an asset class.
While US equities were doing well and outperforming EM, there was always the risk of money going back. With the US seemingly entering a period of relative underperformance, this risk has receded somewhat.
We now have to hope that the rest of the large EM countries continue to remain in as much as a shambles as we see today. Part of India’s allure today remains the absence of other large investable alternatives among the EMs.
Global markets and commodities are being kind, and we have time to put our house in order. While we are likely to see a period of market consolidation and maybe even a mild decline in the coming few months, this should be the pause that refreshes.
Earnings expectations will stabilise and we should start seeing the beginnings of strong earnings growth by the end of this year, and that will trigger the next leg of this rally. Everything now ultimately depends on corporate earnings coming through and profit margins normalising for India Inc.
The writer is at Amansa Capital. These views are his own.
