Headwinds For US Equities That Might Derail The Rally
The impact of a stronger dollar is likely to remain a hurdle for earnings, but U.S. equities are also contending with high relative valuations and a likely increase in interest rates by the Federal Reserve (or Fed) in the second half of this year. As a result, U.S. stocks are still trailing both international developed and emerging markets year-to-date.
In particular, European stocks performed strongly, which was partly fueled by the European Central Bank’s recently announced quantitative easing program, but we are seeing signs of improved economic growth as well.
Market Realist – Headwinds for US equities
The following are the headwinds for US equities going forward.
The US dollar (UUP) has been strengthening against major currencies for the past year, as the above graph shows. This rise in the dollar can be attributed to falling oil prices (USO) (BNO), a strengthening US economy, and soft growth in other parts of the world, including Japan, China, and Europe.
A strengthening dollar may indicate confidence in the US economy. However, it is bad news for US multinationals exporting abroad. The rising US dollar makes American products more expensive, which has a direct impact on company earnings. As per Bloomberg estimates, Amazon (AMZN) has already seen a fall in revenues by $895 million, while it estimates the dollar to reduce revenues by 5% in 1Q15. Proctor & Gamble (PG) expects the dollar to impact $1 billion in earnings. Other behemoths likely to be affected by the rising dollar include Apple (AAPL), McDonald’s (MCD), and Coca-Cola (KO), all of which depend on sales abroad for more than 50% of their revenues.
US equities are richly valued
The previous graph shows the forward price-to-equity multiples by sector for the S&P 500 (SPY). Almost all sectors have forward PE ratios higher than their five-year and ten-year historical averages. The most modestly priced sectors include telecoms and financials (XLF). The six-year-long bull run has caused US equities to become richly valued, especially in comparison to Japanese (EWJ) and European (EZU) equities.
Robert Shiller’s cyclically adjusted price-to-earnings ratio (or CAPE) is defined as the price of a share divided by the ten-year moving average of its earnings. The ratio is used to assess valuations in markets. Currently the CAPE ratio, at 27.6x, is at its highest in the past 10 years, as the above graph shows. The rich valuation might be a headwind for US equities in this year.
Europe continues to be a headwind for US equities
Europe has been suffering from recessionary and deflationary trends in the past year. Though the economy has seen some improvement with a GDP growth rate of 0.3% in 4Q14, as the above graph shows, there is still much to be desired. Though the quantitative easing program may bring necessary relief, it might not be enough if governments do not follow up with structural reforms. What’s more, the Greek debt drama might act as a severe catalyst for financial contagion if an agreement is not reached soon. This might put downward pressure on all global equities (QWLD), including US equities.