Head of Equity Strategy
The equity market momentum has been incredible driven by the continuous realisation over the past year that a US economic recession was not coming and that certain sectors of the economy was in fact booming. This year alone the S&P 500 Index is up 6.5% including reinvestment of dividends, so almost an entire year of normal equity returns has been delivered to investors in just two months.
With Nvidia’s extraordinary results and outlook last week captivating investors and their grandiose statement that generative AI has reached a “tipping point” might be exactly the signal that confirms that the equity market is getting too hot.
Last year we said that equity valuations were not a concern for global equities but US equities were getting increasingly stretched. However, when you have an AI hype then things can get really stretched and our view is now that we have entered a dangerous level again in US equities. As our valuation chart below shows, US equities are now significantly more expensive compared to the average valuation since 1992. In fact, US equities have now reached levels we have only observed during the dot-com bubble and the 2021 technology bubble during the pandemic.
If we take a look at the seven metrics going into the combined valuation metric then we can see that it is really the price-to-sales, EV-to-EBITDA, price-to-cash-flow, and EV-to-sales that are pushing US equities into overvaluation levels. The price investors are willing to pay for sales has been driven by technology companies increasingly dominating the US equity indices because US technology companies have a higher profit margin. The higher the profit margin the more investors are willing to pay for a dollar of revenue. This naturally leads to the conclusions that a lot of the current price level in US equities hinges on assumptions that US technology companies can maintain their abnormally high profit margin.
Our discussion about US equity valuations become even more concerning when we take the equity valuation level today and go back in time to see what that level meant for future returns. The future returns we can lean on is those that came after the dot-com bubble, and here the picture is clear, when you get to these equity valuation levels future returns after subtracting inflation become negative. Can investors really expect that again this time?
The US equity market peaked in terms of equity valuation in December 2021 which was just before the big readjustment of equity valuations as interest rates began to ascent getting the point from the Fed that inflation was more entrenched that initially thought. We are now 26 months into this cycle of investing in US equities from an alarmingly high starting point in terms of valuation. Since December 2021, the S&P 500 Index has returned 2.4% annualised while US inflation has risen 5% annualised over the same period. So already a bit more than 20% into this new period of future returns from levels that even exceeded those during the dot-com bubble, we are seeing equities falling behind delivering a negative annualised real return of 2.6%. It is our fiduciary responsibility as market professionals to warn investors about the current dynamics in US equities.
For investors it means that it is probably a good idea to act on what we are seeing in the equity market. Our view is that it is always best to be invested so investors should increase their cash position, but instead think about how to diversify their portfolio to mitigate the valuation risk in US equities and in particular US technology stocks. Here are a couple of options to consider:
2024: The wasted year
Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
