Concentration is perhaps the concern which currently receives the most attention. In the US, the 10 largest companies account for over 30% of the market value of the S&P 500, the highest level since 1980.
US tech is now as large a share of the US and global market cap as it was in 2000. With the strong market run driven by so few stocks, any reversal in the earnings expectations for the 'magnificent seven' could see a speedy volte-face in the S&P 500’s performance.
As well as the market’s concentration levels, given the strong relationship between valuations and subsequent returns over the following decade, high valuations in the US could also be cause for concern. According to Bank of America research, today’s multiple of 25x normalised earnings implies a much lower expected return of 2.6% annualised over the next 10 years.
High valuations are not only associated with lower returns but a higher likelihood of drawdowns. The expensiveness of the US, which now makes up over 60% of the global market, may give investors pause.
Finally, the yield curve, often touted as a harbinger of recessions when inverted, has now been inverted for 423 consecutive trading days, the longest inversion ever. And while no law requires markets to fall after a period of strong performance, the US market’s recent run has been remarkable – the S&P 500 has now gone over a year without a single daily fall of over 2%.
Reasons to be optimistic
Although the US market is indeed concentrated, there are some good reasons why the US equity market has become more dominant. Since 2008, the earnings growth rate of the US stock market has surpassed that of other markets. Although global technology profits have surged since the Global Financial Crisis (GFC), overall progress in other sectors has been minimal. This gap persisted during the pandemic as social distancing measures further bolstered demand for technology compared to other sectors of the economy.
Looking back throughout history, analysis from Goldman Sachs shows market concentration is also far from unusual, with the industry-driving economic growth tending to represent a large portion of the market. The technology sector now is about the same size as the energy sector was at its height in the mid-1950s. It also remains smaller in the index than both transport (which dominated in the 20th century) or finance and real estate which became the dominant part of the equity market in the 19th century.
If we turn to valuations we see that, while elevated, they are some way from the highs of previous bubbles. Japanese stocks traded on a price-to-earnings (P/E) ratio of 67x in 1990, the Nifty 50 traded on a P/E of 34x in 1973, and the leading seven tech stocks traded on a 24-month forward P/E of 52x in 2000 – more than double the 'magnificent seven’s' 25x.
Furthermore, the US valuation premium, driven by the 'magnificent seven', is not extreme when adjusting for its higher level of profitability and returns on equity. When comparing the 'magnificent seven' to the seven largest tech stocks in 2000, cash as a percentage of market cap is higher today than in 2000 (4.6% vs 1.7%), the companies are less indebted (net debt/equity is -36% vs -4%), return on equity is higher (44% vs 28%), as are company margins (27% vs 16%).
For those still worried about valuations, there are plenty of places to look outside the US where valuations remain favourable. The value factor, for example, is approaching levels of cheapness not seen since the pandemic, which itself was the cheapest the factor had looked since the peak of the 'dot-com' crash. Outside the US, European equities are trading at under 13x earnings, a significant discount to their history, and UK equities are even cheaper at 11x earnings.
While inverted yield curves have demonstrated some ability to predict recessions, recessions do not always coincide with equity market crashes. The yield curve’s predictability is weaker for equity and bond market returns, particularly outside the US. Although the yield curve can be somewhat useful for timing the market, it remains subject to significant forecast uncertainty and represents only a single component within the complex and notoriously challenging arena of forecasting.
Finally, taking a longer-term view, we should remember that global markets go up more often than they go down – even when investing at all-time highs. Looking at MSCI World data since 1970, the subsequent 3, 5, and 10-year returns after investing at an all-time high are 9.9%, 9.8%, and 8.7% annualised respectively. Even investing at all-time highs has, in the past, generated extremely strong returns.
Drawdowns should also not come as a surprise to equity investors, as they are the price they pay to receive these higher returns. Since 1970, the average intra-year drawdown for the MSCI World has been 12%. Of all the trading days, the global market has been below all-time highs for 93% of them. Yet, despite these drawdowns and almost always being below an all-time high, the index has still returned over 10% a year.
Should investors be worried?
Is this the peak of the equity market? Some concerns exist, particularly regarding market concentration in the US, high valuations, the prolonged inversion of the yield curve and the market's recent strong performance. However, there are counterarguments: the dominance of the US market may be justified by its superior earnings growth, historical precedence shows market concentration is not unusual, valuations are not at bubble highs when adjusted for profitability and there are still pockets of value globally. Additionally, historical data suggests investing at all-time highs can still yield strong returns in the long run despite inevitable drawdowns.
While concerns remain, the broader historical context and market dynamics suggest long-term equity investors have plenty of reasons to remain optimistic.
Andrew Prosser is head of investments at InvestEngine
