Investors should beware the rally in US equities warns Temple Bar (TMPL ), which believes the market is in the throes of a ‘bubble echo’ that could sink stocks.

The UK equity income trust with a portfolio of £708m has just reached its third anniversary with Redwheel’s Ian Lance and Nick Purves at the helm.

The managers believe not only are UK equities ‘very very cheap’ but the ‘alternatives look pretty awful to us’, particularly when it comes to US stocks which are at a 50-year valuation high.

Lance said the US market has been driven by technology stocks, and in particular the ‘magnificent seven’, which is made up of Alphabet, Amazon, Apple, Meta, Microsoft, Nvida, and Tesla. Year-to-date these stocks are up at least 50% and in chipmaker Nvida’s case has gained 250% on the back of artificial intelligence hype.

While technology investors may be cheered by the turnaround from the sell-off of 2022, Lance warned that the rebound in ‘a bubble echo’.

‘When bubbles burst they don’t burst normally, in a smooth line, you get peaks and troughs,’ he said.

‘The Nasdaq, from 2000 when it burst, ended up losing 70% of its value over the next two years but within that there were two 40% and one 30% rallies, which is the typical pattern when a bubble bursts and I think we are following the same pattern.’

One thing that is different than 2000 is that the technology companies have even greater dominance and Lance said ‘from a historical perspective, I would be nervous if I have high exposure to US tech companies’.

Investors are still piling into tech stocks at high valuations because ‘they think they will grow rapidly’ but Lance said the ‘revenue growth rates are slowing’.

‘Elephants can’t dance. These companies are large so it is mathematically likely that their growth rates will slow,’ he said.

By contrast, UK stocks are offering lowly valuations. Historically the UK has traded at a 17% discount to the MSCI World index but today it is at a 45% discount. When UK sectors are compared with their US equivalent, they are trading at ‘significant discounts’.

‘UK energy effectively has the same exposure as US energy and BP (BP) and Shell (SHEL) have less than 10% profit coming from the UK but they are trading on a multiple of 5-6x, whereas Exxon is at 11-12x,’ said Lance (pictured).

He added that investors can ‘still make very good returns in UK equities’ instead of being ‘obsessed with the S&P 500 and the seven stocks within it’.

The track record of the fund proves this thesis, gaining almost 80% over the past three years versus a 39% rise in the FTSE All Share, and the S&P 500 up just over 40%.

One low valuation that the duo have taken advantage of recently is Stellantis, an auto manufacturer created by the merger of Italian-American group Fiat Chrysler and and French PSA Group with headquarters in Amsterdam, which now makes up around 3% of the fund.

Purves (pictured) said the share price of the world’s largest auto company by revenue shows ‘the extent to which investors fear cyclicality and will push down the value of shares on fears of a slowdown’.

Purves noted the 2021 merger has given Stellantis the ‘tools to take out a significant amount of costs which is helpful for profitability’.

‘It has been through a very good period, we had lots of pent-up demand because of lockdown...at a time when supply had been restricted by problems in the supply chain,’ he said.

Despite this, Purves said Stellantis trades on an ‘extraordinary valuation’ of enterprise value/EBIT of 1.5x and ‘in theory in 18 months the company can generate enough EBIT to pay back its entire enterprise value’.

Although the company is conservatively financed and has a significant amount of net cash on the balance sheet totalling a third of its market cap, Purve said it is unrealistic to think profitability can continue as it has.

‘The industry is enjoying a very good period but as the economy gets more difficult then profitability could turn down,’ he said. ‘Although there is no sign of it yet.’

With a reduction in profitability down to normal levels, Purves said the company would be trading on a price/earnings of around 5x but still paying 25% of profits as dividend to provide a yield of 9%.

He compared this to Tesla, which operates in the same industry, which is valued at 40-50x earnings,’ he said.

‘The reason I like a [low] price earnings is because there is a chance of it derating lower but it is unlikely. It is more likely the shares will enjoy a rerating but with high-flying companies the risk is for a derating. By buying these exposures [to low valuations], you are stacking the odds in your favour.’