Donald Trump’s election has put fire in the belly of the US stock market. Investors have become excited about the dealmakers in his administration and his plans to cut taxes and spend big on roads and other infrastructure projects.
The likely flipside of rampant government spending is higher inflation and interest rates. But judging by the stock market’s response to the recent interest rate rise by the US Federal Reserve, people seem convinced Trump’s pro-growth agenda will outdo those risks.
Never before has the S&P 500 Index, the main yardstick of American markets, been at such dizzying heights.
Of course the value of the index alone isn’t a great measure of whether the US stock market is cheap or expensive. But other respected valuation measures suggest the easy money has probably been made since the current rally started in 2009.
One example is the cyclical adjusted price-to-earnings ratio, otherwise known as “Cape”. Cape helps us find out if the market seems cheap or expensive.
It compares companies’ average annual earnings over 10 years (adjusted for inflation) with their share price. For instance, a company trading at £10 a share, with average annual inflation-adjusted earnings per share over 10 years of £1, would have a Cape score of 10.
The current Cape score for the S&P 500 index is 29.8 – high compared to history. Since the 1880s, it has only been higher in 1929 and at the peak of the dotcom boom in 1999.
Seasoned investors will know market measures like this help take today’s temperature, not tomorrow’s. And Cape is an average measure. There are still pockets of value in American markets, just as there are pockets of excess. But statistically speaking, the higher stock markets move away from the Cape’s long-term average, the greater the chance of heavy weather ahead.
For us, there is no advantage in trying to second guess the next political move. That said, our 21pc “short” position in America, betting against the US, is one of the largest country risk exposures we have in the strategy at the moment.
Why? Our reason essentially boils down to the strength of the opportunities we have been finding in that market. A number of stock prices seem too high to us and appear to be ready to fall.
To quickly explain long and short investing. When you buy – or “go long” – a stock, you are betting that the stock will rise in value. Taking a short position is the opposite and you make money from the stock price falling.
In the US in particular we are negative about some global industrial and well-known food companies that are considered high quality and “safe” by many investors. To us they actually appear expensive and risky – their prices leave little room for unexpected news that could easily upset the applecart.
We are also finding many so-called “glamour stocks” that have exciting investment stories, such as innovative products, business models or star entrepreneurs, whose prospects have been propped up by creative financing that has left some balance sheets looking unhealthy.
One consequence of low interest rates and rising stock markets is that companies have been able to borrow money incredibly cheaply. This has led to overconfidence in some management teams and complacency among some investors.
Companies with little wriggle room when it comes to their debts could struggle if US interest rates continue to rise. We have shorted social media, technology and pharmaceutical stocks that we think will fall foul of this.
We haven’t bet the house on the US going down. But the fact that our short exposure the US is currently the largest in the strategy may say something about the broader valuation of that market.
In the fullness of time, soaring stock prices and rising interest rates might be the deciding factors that keep Trump enthusiasm in check.
James Clunie is manager of the £1bn Jupiter Absolute Return fund.