Cheap No More

Seven years. That’s how long it’s taken U.S. stocks to claw their way back from the depths of the financial crisis to a place called expensive. Companies of all sizes – small-, mid-, and large-caps – are trading well above their average historical valuations. The trailing 12-month price-to-earnings ratio of the S&P 500 was 18.6x as of the end of January, compared to a long-term average of about 15.5x. Last year, the total return of the S&P 500 was 13.7 percent, but if history is any guide, it could be much lower this year.

The returns since the trough have been substantial, but here comes the downside of the upside: according to Credit Suisse’s U.S. equities strategists, current valuations are consistent with 12-month returns in the low single digits. In January, the U.S. was the worst performing region for both small- and large-cap stocks on a price return basis, down 2.8 percent, which excludes interest and dividend income. Stocks in Asia-Pacific were the best performers (up 1.7 percent), followed by emerging markets (0.4 percent), while European stocks had slightly negative price returns (-0.3 percent), but still outdid the U.S.

Despite that poor showing, however, U.S. stocks are still trading between 1 and 1.5 standard deviations above historical valuations — and many of them much higher. That’s particularly true of sectors that would be expected to benefit from a boost in consumer spending, thanks to cheap gasoline and heating oil. Food and staples retailers, for example, are trading more than two standard deviations above their post-2004 averages. Most retail, consumer durables and apparel, beverage, and tobacco stocks are also richly valued compared to their 10-year averages.

Sectors that don’t experience a direct benefit from cheap oil are trading high, too. Utilities are trading more than one standard deviation above their long-term averages, while the pharmaceutical, biotech, and life sciences sector is close to a full standard deviation above the norm. Consumer services, materials, and commercial and professional services are also priced higher than their historical averages.

That’s not to say that there are no stocks trading below their averages. Thanks to the sharp decline in crude oil prices, the energy sector is the cheapest of the 24 in the Russell 1000 index, with valuations the lowest they’ve been in three decades. Indeed, Credit Suisse U.S. Equity Strategist Lori Calvasina is optimistic that the bottom is nigh. The proportion of energy companies revising earnings upward is now just 25 percent, an indicator that bearish conditions might be reaching a trough. The last time so few companies were making upgrades to earnings targets was in 2012, in the midst of the European debt crisis and weak global growth. Before that, it was 2008, the nadir of the financial crisis. Many sell-side analysts’ have also dropped their buy ratings on small-cap energy stocks, many of which are highly leveraged, and to a lesser degree, on large-caps as well. That’s another indicator that market sentiment is getting more and more pessimistic – and that soon, it might be time to turn bullish.

Credit Suisse also expects energy companies to get a bit of a reprieve as the year progresses as crude oil supply dynamics begin to shift in their favor. Recently, prices of both West Texas Intermediate and Brent crude oil staged a rally, with WTI rising from a 52-week low of $44.38 on Jan. 28 to $52.34 on Feb.6 and Brent jumping up to $57.80 after hitting a low for the year of $46.79 on Jan. 13. Credit Suisse’s energy analysts are reluctant to call the upward trend a lasting one given a lack of change in supply or demand dynamics, and they expect the global oil glut driving prices down to continue in February and March, with prices dipping into the $30-$39 range. But by year-end, production cuts should help prices of WTI and Brent crude grind back to $75 and $80, respectively.

Calvasina also points to attractive valuations in U.S. banks and financial services. Many major banks reported lackluster earnings in the fourth quarter of 2014, and enough investors dumped the stocks to make them the worst performers in the Russell 1000 in January. In other words, if you want cheap in the U.S. market, you’ve got to be contrarian, trying to catch the falling knife of energy stocks or the ongoing drama that is U.S. financial services.

It’s much easier to find attractive valuations outside the U.S.  The MSCI Europe Large Cap index is trading at a price-to-earnings ratio of 16.6x, while the MSCI Japan Large Cap index is trading at 15.3x. Credit Suisse’s Private Banking and Wealth Management division (PBWM) now prefers the European and Japanese markets to the U.S. – not only are they cheaper, but their respective monetary policy stances are more attractive. The U.S. Federal Reserve is on the verge of raising benchmark interest rates for the first time since 2006, whereas the Bank of Japan added to its monetary stimulus in October 2014 and the European Central Bank introduced its first-ever quantitative easing program in January.

As a result of the three regions’ diverging growth patterns and monetary policy stances, the euro has fallen 17 percent against the dollar since last year, while the yen has dropped 17.5 percent. In recent earnings reports, U.S. companies from Proctor & Gamble to Caterpillar have cited the strong dollar as a significant headwind to earnings, while Japanese companies such as Toyota and Nissan have said the weak yen is boosting profits. European exporters are expected to start reporting currency tailwinds in the coming months, too. The U.S. economy may be the strongest in the world at the moment, but its stocks are no longer the sweet deal they once were.