Much has been written about the valuation of the US equity market. The most obvious, objectively correct, and not particularly helpful, talking points are:
• Based on traditional valuation metrics, US equities are very expensive relative to history.
• US equities are at a record high valuation relative to the rest of the world.
• Depending on your time horizon, US equities are expensive (post 2005) or moderately cheap (post 1980s) relative to US bonds.
• Most of the time, high equity valuations mean expected long term returns are low. Most of the time, high valuations provide no insight into short to medium term returns.
We think we can add to the debate by outlining how we consider equity valuations and returns within the context of our strategic asset allocation framework. We also analyse the Tech Bubble of the 2000s, the most obvious historical precedent to today, to see if there are any asset allocation insights to be gained. Finally, we discuss the possibility that despite the current starting point, US equities outperform the rest of the world in the coming decade as they did in the last.
Capital Market Assumptions
We are currently formulating our strategic asset allocations for 2021, a process we undertake annually. In our capital market assumption framework, valuations matter for long term equity market returns, alongside other factors such as earnings growth, buybacks and dividends. There is a clear linkage between returns ten years forward and current valuations.
Since last year’s review, US equity markets have risen around 40%, compared with a 25% increase in Australia and Japan and a 20% increase in Europe. Clearly, relative valuations have worsened. While we have a bespoke method of assessing valuations, our modelling suggests that the US market is even more expensive relative to other regions now than last year. This can be seen in the left chart below. US equities are the most expensive market in every capital market scenario we model. Because of this, and despite some differences across other equity market return drivers, expected returns to US equities are the lowest of every region.
In a purely quantitative portfolio optimisation process, a strategic asset allocation under these assumptions would hold very little US equity exposure. However, it is important to frame these assumptions and outputs with the uncertainty present when making such predictions. Five years ago, the US market was trading at a 100% price to book premium relative to the rest of the world – a record high. However, in the subsequent five-year period, US equities returned nearly double that of the rest of the world. Quantitative capital market modelling does a poor job of predicting thematic trends, such as the global dominance of US technology giants. Stochastic, or simulation, modelling helps deal with that uncertainty, but ultimately qualitative experience is as important as quantitative tools in portfolio decision making.
The Tech Bubble Experience
After highlighting the difficulty around trying to forecast the future, let us imagine an investor who happened to have perfect foresight as to when the 2000s Tech Bubble would pop. The perfect investor could see that broad US equity market valuations were egregiously expensive (as they are now) in both absolute terms and relative to the rest of the world. The investor would have also known that valuation excesses were largely concentrated in the tech and health care sectors of the US (see below).
Armed with the knowledge of when the Tech Bubble would burst, the investor constructs a portfolio robust to the obvious outcome – one built with better valued countries and sectors. The investor reduces exposure to US equities overall and moves away from the technology and health care sectors. Surely this portfolio outperforms over the correction.
Of course, outperformance is not guaranteed, as nothing in investing is as simple as it seems. The overall US equity market marginally outperformed the rest of the world during the drawdown. At the sector level, the investor was correct that the tech sector was hit hard, but the US tech sector marginally outperformed tech in the rest of the world. Health care also happened to be one of the better performing sectors during the drawdown. The consumer sectors in the US also substantially outperformed their rest of world counterparts, delivering positive returns while every other sector fell. If the investor had not timed the market top perfectly, the loss would have been even greater given the stellar run in US tech stocks prior to the correction.
Part of the reason the investor experienced such poor performance even though they timed the bursting of the bubble correctly is because valuations are not the only driver of markets, particularly over shorter time horizons. The US and European economies fell into recessions in 2000/2001. In the US, despite the Tech Bubble bursting in early March 2000, the rest of the equity market held its ground for six months and didn’t start falling until it was clear that the economy was entering a recession (the ISM Index fell below 50 in August, implying a contraction in manufacturing activity). The US Federal Reserve was able to cut interest rates meaningfully more than the European or Japanese central banks. Trailing earnings also only fell half as much in the US versus the rest of the world.
The point we are trying to make in the somewhat facetious example above is that even though we know the US market is expensive relative to history and much more expensive than the rest of the world, that condition isn’t enough to cause an equity market correction or even US underperformance should a correction occur. Portfolio construction requires deeper consideration than valuations alone.
Can the US Market Continue to Outperform?
While high valuations and low expected returns don’t guarantee US underperformance, they do tilt the deck towards that outcome, particularly as time horizons extend. So, what would it take for the US to shake off the valuation anchor and continue to dominate the rest of the world?
As we have mentioned in previous Market Insights , the current dominance of US tech companies is different to the Tech Bubble. These companies have a track record of delivering above market earnings due to a combination of first mover advantage, monopoly power, network effects and scale. That they have delivered these earnings in a low growth environment has further cemented their success. Absent substantial regulatory change to break up their monopolies, tech companies will continue to cannibalise their competitors and increase market share. If interest rates stay anchored, multiples are not likely to come under too much pressure.
Even outside of the tech sector, US companies have a good track record of delivering earnings relative to their counterparts in the rest of the world. Since 1995, overall earnings growth in the US has averaged around 16%, compared with 14% in emerging markets, 11% in Europe, 6% in Australia and 3% in the UK. Japanese equities have delivered stronger earnings growth, but that is from an exceptionally low base following the 1990s recession. US earnings outperformance has accelerated in the post Financial Crisis period even excluding the impact of big tech companies.
The US produces the world’s most successful companies for a variety of reasons. It is an enormous single currency, single language market full of wealthy potential customers. Regulatory and legal structures are amenable to growing a business. It is easier to raise debt and equity finance on Wall Street than in La Défense or Bankenviertel. The Americans have an entrepreneurial spirit unmatched elsewhere which draws the world’s best and brightest.
If, following the post Covid stimulus induced rebound in global economic growth, the world moderates back to the post Financial Crisis experience of persistently low growth and inflation, global investors will continue to be willing to pay a valuation premium for exposure to US companies which can deliver growth in a low growth world.
Portfolio Construction Implications
The obvious portfolio construction implication from the above is a need for flexibility. While we can improve long term expected portfolio returns by having less exposure to US equities – that assumes we cannot actively manage the portfolio, which we can. A better return profile could be achieved through being aware of both long-term valuation issues and the shorter-term catalysts which could trigger their realisation. We have substantial scope to quickly reduce exposure to problematic sectors of the market if the investment environment deteriorates.
While the US market looks unattractive in an absolute sense, there is also considerable dispersion within the market. We can, and do, also hold exposure to equity managers with substantial US exposure trading at quite cheap valuation multiples. Recall, despite higher relative valuations, the best performing sectors in the Tech Bubble drawdown were in the US. A good manager, with the flexibility to manage their book, can go a long way to improving portfolio outcomes during a market drawdown.
 In the medium to long term, we construct a fair value Forward PE and Shiller PE by applying the historic average equity risk premium to our long run expectations for risk free interest rates in each major region. We then adjust these required earnings yields higher (meaning a lower fair value PE) by the reduction in economic growth expected in the future relative to history for each market. In practice, this balances the effect of lower discount rates (which should boost equity valuations) and lower economic growth (which should lower valuations).
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