Despite the COVID-19 crisis, the US economy did quite well in 2020. According to the Fed’s Economic Projections on Dec 16, 2020, the real GDP for 2020 is expected to be -2.4 percent and the nominal GDP is -1 percent. This is an excellent economic performance given the lockdowns, stay-at-home advisories and business and supply-chain disruptions that happened during the year.
Further, the US Fed expects the economy to continue doing well over the next three years. The US GDP (nominal) is expected to grow at 6 percent for 2021, 5.1 percent for 2022, 4.4 percent for 2023 and 3.8 percent beyond that.
However, there is a concern that the US markets are in a bubble. This hypothesis can be resolved analytically by looking at the valuation ratios to begin with. This will also lead us to potential investment niches that are more promising.
Taking the valuation call
As of Nov 30, 2020, the S&P 500 sports a PE (projected) of 22.94; the S&P 400, representing the 400 US mid-cap stocks trades at a PE (projected) of 20.03; and, the S&P 600, representing the 600 US small-cap stocks is at a PE (projected) of 19.97.
The inverse of the PE ratio is called the earnings yield. This means the earnings yield for US markets is 4.3 percent for the large-cap stocks and 5 percent for the mid and small-cap stocks. These figures look quite fair given that the Fed fund rate is at 0.1 percent and the US 10-year Treasury notes are trading at 0.95 percent.
Further, the S&P 600 has barely crossed its previous 2018 peak in the middle of December, while S&P 400 crossed its 2018 and Feb 2020 peak in November 2020. In that sense, these two categories of stocks have barely reached the same valuation levels which were achieved more than 2 years back.
You can infer that while the large-caps are also fairly priced, the mid and small-caps are likely even more promising in terms of being available at a discount to their fair value. The likelihood of finding 20-30 stocks fundamentally strong, i.e., super normal companies, at a discount to their intrinsic value, i.e., super normal prices, from the full stack of 1500 large, mid and small-cap stocks is quite high.
Concentrate on segments such as information technology, the consumer discretionary, consumer staples, communications and industrials. One could also focus on promising themes, such as Artificial Intelligence (AI), Internet of Things (IoT), Cloud computing, 5G, Luxury retail, quantum computing, self-driving cars, sports & wellness, athleisure, work-from-home, play-from-home, AI chips, among several other interesting themes.
Getting carried away by fancy themes
An important caveat to keep in mind is not to get lured by exciting themes, but to use exciting themes as a starting point and dig deeper into the fundamental aspects of the companies, such as, the strength of their balance sheets, cash flows, growth rates and prospects etc. and also compare that to what you are paying for the same in terms of valuations. If you are getting fundamentally strong companies with significant growth prospects at reasonable prices, such that the expected returns are still in high single digits to double digits then that would be a strong pick for your portfolio. Our analysis shows that there are such possibilities, if one is able to keep an eye out for such stocks digs deep in the S&P 1500 to identify those.
Do not invest in a story stock. These are stocks about which there is mostly positive and highly optimistic news floating around and the stock prices are only going up. It is also broadly advised that you shouldn’t ask about its valuations since they don’t matter. Be careful about these kinds of stocks.
Some more pointers for stocks to be avoided are: very high PE ratios, sometimes even negative earnings, low or negative cash flows and high debt to equity.
With a strong Rupee, the current time is an opportune to start investing in the US markets. Let 2021 be the year when you start your US investments. As discussed above, it is probably better to invest in specific opportunities rather than broad level index ETFs since the niches offer a more favourable risk-reward balance. An initial lumpsum followed by an SIP monthly can help benefit from any market or currency fluctuation.