U.S. equities’ bull run limits future upside

We are now in year eight of a U.S. equity bull run. U.S. equities, as defined by the…

We are now in year eight of a U.S. equity bull run. U.S. equities, as defined by the Russell 3000, have returned 15% on average since 2009, making this their second-longest hot streak since a decade-long run in the 1990s. Thanks to the global monetary stimulus policies of the Federal Reserve and other central banks, equity investors have reaped the benefits of double-digit gains in six out of the last seven years.
But is this trend justified? Yes, the U.S. economy continues to hum along right at around 2% annualized growth. Unemployment has ticked down as individuals have reentered the labor market and found work, and corporations have rebounded in terms of sales and earnings growth. We also see consumers going about their business and supporting the economy with additional spending.

RELATIVELY EXPENSIVE

Yet do those data points indicate a positive view for investors in the U.S.? I would argue certainly not.
For starters, valuations for U.S. equities are much higher than their historical rates. In fact, they look relatively expensive compared to equities in other parts of the world, including Europe, Asia and Latin America.
Additionally, the key drivers behind corporate profits in this most recent expansion have not been operating growth or reinvestment by firms in their own businesses. Instead, executives have focused on cost cutting and share buyback programs to deliver value to investors.

All of this, however, has caused balance sheets to deteriorate as many of these activities have been funded with record levels of borrowing in the corporate bond markets.
Finally, with the Fed in a slow tightening cycle, the pressure on companies to deliver results that exceed required rates of return will only increase. This will leave a limited number of companies that can grow at a rate that creates value for shareholders.

CHEAP MONEY

Why would investors bail on U.S. equities in favor of international equities? It’s quite simple. With cheap money slushing around the world, the case for international stocks improves because there is an incentive for investors to own risky assets over safe government bonds. With the European Central Bank and the Bank of Japan both operating with negative interest rates, investors will have to own stocks to earn positive returns.
There are also added benefits. International equities are trading at much cheaper valuations than their U.S. counterparts, and that’s especially true for emerging-market equities, which bore the brunt of the decline in 2015.

(Related read: Advisers ambivalent about emerging markets)

Emerging-market countries are also in the midst of transitioning from export-driven economies to those focused on domestic demand and consumer spending. This is especially true for countries that have invested in training their labor forces and bringing regulatory and fiscal stability to their economies.

LIMITED UPSIDE

Overall, the case for U.S. equities over the next few years is weak compared to global markets. Every vital piece of information points to a limited upside for U.S. equities until valuations pull back from their extraordinary levels.
International equities are more attractively priced given their lower valuations and monetary support from central bankers fighting to prop up their economies, and emerging-market equities stand to gain the most as they are best-positioned to benefit from the coming rebound in global growth and commodity prices.
Joe Smith is a senior market strategist at CLS Investments.