With the S&P 500 Index setting 10 new daily all-time closing highs during the second quarter, domestic equity markets continue to appear yet more overvalued on an absolute basis while international markets appear relatively more attractive. As illustrated below, the current forward 12-month price/earnings ratio of major indices (with the exception of Japan) are in the upper quartile of weekly observations since the date referenced in the chart. The current 12-month forward price/earnings ratio of the S&P 500 and S&P 600 are currently higher than 82% and 93%, respectively, of weekly observations over the time period noted in the chart. Conversely, the current 12-month forward price/earnings ratio of the MSCI Japan Index is currently lower than 72% of weekly observations over the analysis period.
As the Fed is in a tightening posture and corporate earnings growth continues to be challenged, the US appears to be nearing the end of its 8-year bull market. In Europe, however, recent political events, including the election of Macron in France and the continued stimulus implemented by the European Central Bank, have created an environment supportive of growth, justifying the relatively high valuation. Japan, facing economic pressure largely driven by unfavorable demographics and the uncertainty created by North Korea, is relatively cheap compared to its history. Thus, we maintain a neutral/underweight posture on domestic equities and are raising our outlook for EAFE equities from neutral/underweight to neutral.
Domestic public fixed income markets (both high-yield and investment grade) also appear to be overvalued. As illustrated below, investment grade and high-yield spreads have tightened by ~110 bps and ~480 bps, respectively, since their early 2016 highs. These tight spreads are evidence that public fixed income may be largely “priced to perfection” and that any stress in the credit market could cause spreads to blow out quickly and substantially. For this reason, we continue to recommend a neutral/underweight posture on domestic public fixed income.
Because public domestic equity and global fixed income markets appear to be overvalued (in some cases substantially), we continue to recommend that investors focus on private markets, both equity and debt, wherein managers often have the ability to capitalize on inefficiencies, and investors can capitalize on illiquidity and complexity premiums.