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Investors are concerned that the US market is too expensive. Scratch the surface and a different picture emerges, says David Zhao, Co-Manager of the BlackRock North American Income Trust plc.
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Stock markets have recovered from their March lows, but there is increasing concern that the US market may have got ahead of itself. Investors fear that US stocks now look expensive relative to their global peers and little value remains The reality is more nuanced.
Investors tend to see the global technology companies as a proxy for the US market. However, it is important to remember that the US is the largest and most diverse stock market in the world. Many of the recent gains have been concentrated in the technology sector, but there are lots of companies that have been left behind.
We would argue that part of the recent rise in some parts of the US market makes sense in the context of a lower ‘risk-free’ rate – the rate investors can get on cash. With interest rates at all-time lows, future cash flows become more valuable, which means it makes sense for high growth companies such as some of the technology names to trade at higher valuations. When this is taken into account, the overall ‘equity risk premium’ - the extra return investors get for investing in the stock market – hasn't increased significantly.
Equally, while the aggregate value of the market has risen, it masks significant polarisation between different sectors in the market. The ‘COVID-19 winners’ – areas such as technology that have benefitted from the changing climate – have seen valuations expand significantly. Even though their earnings have been strong, their share price growth has been even stronger. This is in notable contrast to unloved areas such as financials, healthcare or utilities. In general, these stocks have seen their share prices fall more than their earnings.
Today, by our calculations, the cheapest stocks are on record lows, even lower than during the Dotcom era. That is not necessarily a reason to invest in itself, but it does show that it is not the market as a whole that is expensive, but rather a narrow tier of high-profile stocks.
There are other factors that are also influencing markets. We have seen the return of the day trader. People who are quarantined or working from home have more time on their hands to trade. They tend to concentrate their attention on higher profile companies, and this is affecting market movements.
There has also been a lot of capital sucked into so-called ‘blank cheque’ companies. These are companies that take investor capital on the understanding that it will be invested in a specific asset. These have formed around one-third of IPOs this year. This also raises the aggregate valuation of the market but doesn’t necessarily make the broader market expensive.
A return to normality?
There is an argument that until a vaccine is found and life can return to some semblance of normality, the market will continue to prioritise companies with reliable growth. However, our research suggests that those companies with strong share price growth early in a recession tend to give up that strong performance later on. This makes intuitive sense. At the start of a recession, investors take comfort in those stocks they know have worked and that seem relatively immune to recession. However, too much expectation can be built into those companies and the level of enthusiasm wanes as the recession progresses.
In the BlackRock North American Income Trust, we are keeping our focus firmly on high quality, cash generative companies that can grow their dividends over time. To our mind, these are principally found in three areas – financials, energy and software companies. There will inevitably be some volatility around the election, whoever ends up in the White House, and we believe these areas should avoid some of that volatility.
In financials, we are focused on insurance companies and banks. Banks in particular have been hard hit in the crisis, in spite of significant improvements in their cash position – and therefore risk – over the past decade. In energy, we invest not directly into oil and gas companies, but into energy infrastructure areas such as pipelines. In software, we are avoiding pockets of over-valuation and focusing on those companies with a predictable growth trajectory.
To dismiss the US market as universally expensive would be a mistake. Certainly, there are areas where valuations look extended, but look more closely and there is real value in the US market that investors may be missing.
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