What does the US economy tell us about sector valuations?

US equities have declined year-to-date driven by growth concerns. Fundamentals suggest the US market and most sectors are undervalued. However, valuations seem to broadly confirm our sector allocations. Our models suggest that if the US consumer remains robust and inflation low, then there is upside potential in the market.

The equity market sell-off this year has been savage and seems to have caught most investors by surprise. Although we reduced our exposure to equities in our last The Big Picture, we have been Overweight the asset class through all the volatility. The US has suffered less than Europe, despite more challenging valuations. Within the US market, defensives have done better than cyclicals in general. After all this volatility, what do US sector valuations tell us today? Have any opportunities opened up?

We have extended the work we did in What’s in the price of US banks? to explore how they influence sector valuations (cyclically-adjusted price/cash flow in this case – the best indicator in the US, in our view). We used the following independent variables (see Figure 1 for coefficients on the market as a whole):

• 1-year change in: oil price, copper price, new home sales, USD index, consumer price index, disposable income, average hourly earnings, USD/EUR rate
• The level of: ISM manufacturing index, consumer confidence index (conference board), unemployment rate, yield curve (10y-2y yields), net debt/EBITDA (only for non-financial sectors), EBITDA margin, return on equity

We exclude net debt/EBITDA when we look at the whole market to take account of financials, where debt provided as products would confuse results.

We are mindful that using so many variables can lead to overfitting, but we are confident that they are independent enough from each other to ensure that our results are meaningful. In addition, R2 statistics (coefficient of determination) were above 55% for all sectors, but one – utilities with 40% –, which suggests that the model has good explanatory power.

The variables which seem to influence US sector valuations the most are (where they were statistically significant): the year-on-year change in average hourly earnings, the CPI inflation and the level of the unemployment rate (Figure 1 illustrates this well). In fact, for all sectors, except utilities (where none of them proved significant), one of these three variables proved to have the highest coefficient. Whether using these three variables is sufficient is an important question, which we might explore in the future, but we feel that, because each sector is driven by different fundamentals.

The next step is to calculate what the cyclically-adjusted price/cash flow should be based on our model and compare it to ratios observed currently (see Figure 2). Overall, the market itself looks undervalued by 19%, suggesting that the variables that have in the past explained variations in valuations are still supportive, despite the obvious concerns currently being expressed by the market.

Broadly, resource-related sectors, including utilities, still look overvalued, suggesting that currently they are more “value-trap” than value. Most financials are on the undervalued side of Figure 2. Thus, valuations seem to validate two of our most important sector allocations.

The rest are not so clear when we look at the differences to the model-predicted ratios in absolute terms. However, if we compare how much they are under- or overvalued compared to the market, the results are broadly in line with our sector allocations.

Even if we based our decisions only on this model, we would make few changes to our allocations. Among our Underweights, only telecoms shows up as more undervalued than the market and only two of our Overweights look more overvalued than the market.

So far this year, markets appear to be edging toward the Depression scenario outlined in our 2016 outlook. If that unfolds, the economic variables used as inputs to our model will be radically different and defensive sectors would continue to be favoured. However, we suspect that underlying strength in the US economy will eventually normalise market conditions. If so, higher hourly earnings, low unemployment and continued low inflation should support US equities and our current sector allocation. The continued strengthening of the dollar might counteract these forces, but it seems to have less influence.

Paul Jackson – Head of Research – Source
András Vig – Research Director – Source