Despite signs that most of the U.S. economic softness of the last three months was weather related, equities have struggled to push higher lately. The recent sluggish performance of U.S. stocks, especially those in the biotechnology and technology industries, is leading some market watchers to question whether we’re witnessing the bursting of an equity bubble.
My take: I don’t believe that U.S. equities overall are in a bubble. Though stocks certainly are no longer cheap, valuations are still a long way off from the late 1990s or the run-up to the 1987 stock market crash. That said, valuations certainly have started to become an issue, particularly for certain segments of the market.
For instance, at more than 25x current earnings estimates, valuations for small caps look outright expensive. And particular pockets of the market – like last year’s growth stocks–are verging, or have already tipped into, bubble territory. The average price-to-book ratio for the Nasdaq Biotechnology Index is more than 7. As for Internet stocks, we are back to a world reminiscent of the late 1990s, where only the most creative metrics can justify the premiums being paid for certain companies.
Does all this suggest that the market has peaked and stocks are likely to come crashing down? Not necessarily. It’s important to note that not all stocks look expensive. In the United States, the energy, healthcare, and surprisingly technology (not every tech stock is trading like Facebook) sectors are all trading comfortably below their historic valuations. Outside of the United States, stocks in Europe, Japan, and most of developed Asia range from reasonably priced to cheap.
In addition, while the market is certainly vulnerable to a spike in interest rates or an economy slowing more than expected, I don’t expect these scenarios to occur. Rather, given my expectations of modestly accelerating economic growth and continued low rates in 2014, I still believe that the U.S. market will push ahead this year.
So what does this mean for investors? Given that valuations in certain parts of the market do look stretched, investors may need to shift strategies from what worked last year. Here are three moves to consider:
1. Go for value. Rather than chase last year’s winners – a poor strategy year-to-date – investors should consider embracing some of last year’s losers and adopting a general bias toward value-oriented areas of the market, as many investors do appear to be doing. Year-to-date, U.S. value stocks advanced roughly 2.1 %, while U.S. growth equities are flat.
2. Overweight large and mega cap stocks. As I’ve long been advocating, I believe that investors should consider trimming their allocations to small cap stocks in favor of gaining greater exposure to large and mega cap names. To be sure, large cap names are no longer cheap. U.S. large caps, for instance, finished March at 17.25x trailing earnings, comfortably above the 60-year average and the highest level in four years. Yet large caps names have still gained around 1.5% year-to-date, while small caps are down nominally on the year.
3. Embrace international markets. As I’ve been noting for some time, emerging markets can offer compelling long-term value. In the developed world, meanwhile, I like Japan and the eurozone. While Japanese stocks have struggled this year, European equities have outperformed U.S. stocks. And though both Japan and Europe are less profitable, and are likely to grow slower, than the United States, they both possess one characteristic in short supply locally: value.
Sources: Bloomberg, BlackRock Research
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist. He is a regular contributor to The Blog and you can find more of his posts here.