Last week was a good one for U.S. stocks. The Dow Industrials set record closing highs four days in a row and all three major U.S. indices added more than 2%.
What fuelled the rally? U.S. equities have been supported by better-than-expected economic data (including Friday's non-farm payrolls report), showing a U.S. economy that continues to improve despite higher taxes and that can probably withstand a spring hit from the sequester. In addition, amid improving investor sentiment, money has been flowing off the sidelines into stocks.
But while there's still lots of money on the sidelines that could theoretically support the rally going forward, the magnitude of U.S. stocks' advance is starting to cause some indicators to flash yellow.
- Volatility is once again closing in on multi-year lows.
- While the U.S. economy is healing, U.S. earnings are not advancing as quickly as market averages.
- Most of this year's gains have been driven by higher valuations, rather than higher earnings.
- Valuations, though still cheap relative to bonds and cash, aren't as compelling as they were last fall. U.S. equities now trade at a little more than 14x next year's estimated earnings, vs. just about 12.5x last fall.
The bottom line for investors? Considering where U.S. valuations are today and the potential headwinds ahead, I continue to advocate that investors bring down any U.S. overweight and look to put new money to work in international markets.
Within the United States, I would prefer parts of the market where fundamentals have kept pace with the rally. One example: U.S. mega caps, a sector with lower valuations and higher profitability than the broader market. Investors may also want to consider U.S. energy and technology stocks, which also look like bargains now. These sectors are accessible through the iShares S&P 100 Index Fund (OEF), the iShares Dow Jones U.S. Energy Sector Index Fund (IYE), and the iShares Dow Jones U.S. Technology Sector Index Fund (IYW).
At the same time, given the U.S. small-cap sector's particularly aggressive multiple expansion during the recent rally, investors may want to consider reallocating some profits from small caps to less aggressively priced parts of the U.S. market.
Disclaimer: Narrowly focused investments typically exhibit higher volatility. Technology companies may be subject to severe competition and product obsolescence.