Produced by Filip Fortuna. Filmed by Rod Fitzgerald.
What is the boldest contrarian trade in the world right now? The answer, possibly surprising to some, is to invest in large US stocks. Supposedly, smart money is now more convinced than at any time since the financial crisis that the US S&P 500 index is looking dangerously overvalued.
A survey this week of global fund managers responsible for investing $500 billion of assets by Bank of America Merrill Lynch found that 83% of the respondents think US stocks are overvalued, which is the highest number to hold this view since 2008.
Because of these fears, those managing this sizable pool of cash have reduced exposure to the US stock market by 21 percentage points in April, compared to March, ramping up positions in emerging markets in Europe instead. But is it really so obvious that US stocks are expensive? They certainly seem no bargain right now but financial bubbles do not tend to form when the majority of market participants are fearful.
Anyone tempted to doubt the collective wisdom of this wall of cash would do well to consider the following-- the trailing earnings yield on the S&P 500 stands at about 4.6% today, according to Bloomberg data, nearly half the level that it hit during the lows of the crisis. When inverted to a multiple, this works out at a price-to-earnings ratio of 21.5 times evaluation many professionals are right now fretting is just too high.
Their logic is driven by the idea that when rates rise, which they are expected to do, this earnings yield will move higher and the value of equities will fall. Yet history shows it is not always the case. In September 1992, the S&P 500 earnings yield touched a low of 3.7% with the US headline interest rate at about 3%.
By 1994, the Federal Reserve had begun to raise rates, doubling them to 6% and by 1995, this sent the earnings yield to more than 6% on the S&P 500.
So what did US stocks actually do with this sharp movement? Between the middle of 1992 to the end of 1994, the S&P actually rose by 15%. Anyone who had bought in 1992 before rates went up and held to the end of the decade would have made 2 and 1/2 times their money. Investors would do well to remain cautious following an eight-year bull market but should also remain suitably sceptical of the prevailing consensus.