According to traditional valuation metrics, US equities are expensive. In this analysis, we provide two arguments for continued outperformance of US equities, and two in favour of better performance of non-US equities.
Large US equities will deliver a real return of -1.5% per year for the next seven years, according to GMO. At the other end of the spectrum are emerging market equities with a value tilt, with an expected return of 11.8% per year. The bond segment is also in trouble, with negative expected returns across the board.
GMO’s Jeremy Grantham is quite clear in his views. He says: ‘I have not been an active portfolio manager for a long time, but I like to give my opinion: it is very likely that the US market is in a big bubble, the kind that happens every few decades, reminiscent of the late 1990s. This will most likely end badly, although nothing is certain.’
That ‘nothing is certain’ is intriguing though. Is Jeremy Grantham not really as sure as he seems?
The year 2020 was the worst ever for value stocks, with spreads between growth and value averaging 20-30% points in a single year. EM equities are also trading at some of their lowest valuations relative to US stocks for the past 50 years. Therefore, it should come as no surprise that, according to GMO, relative investment opportunities are mainly to be found in the intersection of these two ideas: value and emerging market equities. Avoid US growth stocks as much as you can!’
‘This time is different’
This is what growth believers tend to say. But we see two arguments as to why US equities will underperform other international equities and/growth country equities, and two key arguments that rather argue for continued outperformance.
Against: US equities are very expensive
The historical price/earnings ratio for the US S&P 500 index is 35.1 according to a recent analysis by Factset. That is well above the five-year average of 21.8. It is also well above the ten-year average of 18.9. Since valuation multiples of equity markets tend to return to the long-term average, we can assume that we will see compression in the coming years. Even if profits continue to rise, a normalisation is imminent.
Against: non-US stocks perform better in a cyclical recovery
Schroders recently produced an interesting paper on different asset classes. It shows that non-US equities have historically outperformed US equities in a cyclical recovery.
This is due to the well-known fact that the ‘cyclical exposure’ (see left graph) of US companies is relatively limited. In the 2000s, US equities also underperformed international equities. Meanwhile, the reflation trade continues unabated. Since the announcement of the vaccines in November 2020, global value stocks have risen cumulatively by almost 19.5%. Global growth stocks by ‘only’ 4.5 % in dollar terms.
Economic growth in both Europe and the United States is between 6 and 8% in 2021. There are no signs yet that this will weaken. The reflation trade can therefore continue for some time.
In fevour: Intangible assets significant part of US value creation
No less than 90% of the market value of the 500 largest US companies in the S&P 500 index consists of intangible assets. In 1975, as you can see, that share was only 17%. The world’s 30 largest companies now therefore look very different from the 30 largest companies 30 years ago, as Warren Buffett demonstrated last weekend at Berkshire Hathaway’s online annual meeting. There are precisely zero companies that figure on both lists.
Cathie Wood, the well-known manager and top executive of the disruptive ETF provider ARK Investments, has already said that network effects and intangible assets are a particularly powerful combination. ‘The “secret” of success in truly disruptive innovation these days is that too much capital is chasing the asset light, network effect models that defined success in the old world,’ she says.
In today’s digital world, such intangible assets are more useful than tangible assets. Investors find more of these companies in the United States than in Europe, but Asia in particular is starting to catch up.
In favour: FAMANGs are less expensive than people think
In recent weeks, companies such as Alphabet, Microsoft and Amazon announced their earnings. Almost all of them were much better than expected. Both revenues and free cash flow increased enormously. Together, these companies account for about a quarter of US indices and therefore have an important impact on market performance.
Investors are now realising that these big technology companies are not as expensive as they thought in recent years. For example, thanks to Alphabet’s phenomenal results, the share price-to-earnings ratio has dropped from 33x to 28.1x. This is the lowest level since November 2019. FANG companies meet both value and growth criteria. Large institutional investors are therefore only too happy to include them in their portfolios.
Conclusion
Yes, the US market is (relatively) expensive and other international markets, especially EM equities with a value tilt, offer (relatively) better valuations. In the short term, US equities are likely to underperform, especially as long as the cyclical recovery continues.
In the long term, the US market, the most liquid, deep and shareholder-friendly in the world, still offers many opportunities. Most likely, there will be a greater role for active management rather than the passive management of recent years.