The Dow Jones Industrial Average topped the 26,000 mark for the first time on Tuesday, but investors should approach the US market with caution, according to market commentators.
The index of the top 20 US shares weighted by largest share price number has risen 1,000 points in just 12 days and by 6,000 points over the past year.
Neil Wilson, senior market analyst at ETX Capital, noted: “The stunning start to 2018 continued on Tuesday with another set of records on Wall Street as traders returned from holiday.
“A strong start to earnings season lifted optimism and helped the Dow breach 26,000 for the first time. If earnings keep on at this pace we could see further gains over the coming fortnight.”
However, Ben Conway, manager of the Hawksmoor Investment Management’s model portfolios, said investors should pay very little attention to the index.
“The Dow is a stupid index for a start,” he explained. “It is price-weighted which is nonsense. I don’t even know why people still pay attention to it, I suspect it is just because of historical reasons.
“Our opinion on these sorts of things – even if you’d said it was the S&P 500 – would be that we wouldn’t pay it any attention whatsoever.
“Yes, maybe it is a psychological level and technicians will get excited but we are not great fans of technical analysis anyhow. So, I’m afraid we would put very little weight on it.”
Others suggest investors should look at the wider market, with the S&P 500 – made up of the top 500 stocks by market capitalisation – a more representative index.
The S&P 500 has also risen to new highs early this year and Shore Financial Planning director Ben Yearsley said this is because investors have backed improving earnings estimates on the assumption that tax reforms will help boost balance sheets.
Performance of index over 5yrs
Source: FE Analytics
“There are two things [that boosted the market] – apart from the improving fundamentals of the US economy. One was the rise predicated on Trump getting his tax plans through,” said Yearsley.
“I think there was a bit of surprise when he did and to the level he did and that has had a huge impact on the market.”
Should corporation tax fall from 35 per cent to 20 per cent – as US president Donald Trump hopes to achieve – companies will begin to warrant the high price-to-earnings (P/E) multiples they are currently trading at.
“The second thing is he will probably get through is his infrastructure plans,” Yearsley said, which should get cross-party support and again is expected to give another boost to the US economy.
“However, the negative is purely that the level of the market valuation as you have got to say that it is looking expensive.”
Jason Hollands, managing director at Tilney Group, agreed, noting that, at a headline level, the market has looked historically expensive against longer term trends for some time.
“Last year was particularly driven by strong earnings growth at companies but obviously there is now a lot of optimism loaded into expectations due to the significant tax cuts coming into the US this year which should benefit stock prices and a lot of that is expected to filter into increased stock buybacks,” he said.
“So, there are reasons to be guardedly optimistic on US equities despite historically elevated levels. But the real conundrum for investors is how much of that is currently reflected in valuations.”
One problem is that the shape of the market has changed over time, with technology and media stocks a much larger part of the US market than they were a decade ago.
“There is a lot of talk about FAANG [Facebook, Amazon, Apple, Netflix & Google] stocks and these parts of the market have seen strong share price rises, particularly over the last 12 months and the multiples there do look very high,” Hollands said.
Indeed, over the last decade the technology sector has outperformed the wider S&P 500 by 61.7 percentage points, as the below chart shows.
Performance of indices over 10yrs
Source: FE Analytics
Hollands continued: “Tech companies now account for over 20 per cent of the S&P 500 and the headline level is slightly distorted by that part of the market where there have been very sharp rises in valuations and prices.”
Overall, he said investors should not shun the US market in its entirety – after all it represents more than half of global equity markets by market cap – as it includes a number of world leading companies.
Additionally, the economic outlook is healthy both globally and for the US and such companies should continue to benefit.
“But I think it is important to be aware that when valuations are elevated one needs to exercise a little bit of care as to where you are investing,” he added.
Shore Capital’s Ben Yearsley agreed, noting: “Yes, I have exposure to the US but I have got exposure through funds such as Legg Mason ClearBridge US Aggressive Growth.”
Performance of fund vs sector and benchmark over 10yrs
Source: FE Analytics
While the Legg Mason fund is a growth strategy, its focus on small and medium-sized stocks means it has a much lower average P/E (16x) than the wider market (25x).
“I am more comfortable with that as a long-term bet than buying an index fund at the moment,” Yearsley said.
Tilney’s Hollands said that as many active managers have poor track records over the past decade compared with the S&P 500 index, many investors may be unwilling to back them moving forward.
“Historically a lot of investors have chosen passives for US exposure and that in the past has been a perfectly sensible thing to do as in a momentum-driven market that style of investing obviously works well,” he said.
“But where valuations have gone in the tech sector it might be time for a different approach to the US that is a bit more value-aware either through choosing actively managed funds or, if you can’t bring yourself to do that, there are of course factor funds that will lead to a more defensive approach to the US market.”
He uses the PS FTSE RAFI US 1000 UCITS exchange-traded fund (ETF) for his exposure, a factor fund investing in the 1,000 biggest US companies.
“It re-weights away from market cap based on a basket of criteria including net assets, rewarding companies with strong balance sheets and less exposure to those that are highly leveraged,” he explained.
“It also weights on cashflow, dividends and value ratios so it will give a more conservative profile and more exposure to companies that are perhaps less speculative.”