- US has trounced all other major markets over 10 and 20 years
- £10,000 invested in the S&P 500 10 years ago would now be worth £42,248 compared to £18,186 from the FTSE All Share
- But a widely used US valuation signal is flashing red
- Managing the concentration risk of US and Global trackers
- Only 22% of active US equity funds have outperformed in the last 10 years
Laith Khalaf, head of investment analysis at AJ Bell, comments:
“The US election result will likely have an impact on the short-term direction of markets, especially to assets linked to interest rates. But investors need to put the sound and fury of the US election to one side when considering whether to invest in the US and maintain a longer-term perspective. The US is the largest and most influential stock market in the world by far, and performance in recent years has been nothing short of exceptional. But there are legitimate concerns about the valuation and concentration risk of the US market which has resulted from the unbridled rise of big tech.
Blockbuster performance
“The US has been the best performing major market over the last decade by a country mile. On top of the stock market performance, UK investors in the S&P 500 have enjoyed a boost from a weaker pound, which has turbo charged their already sky high returns. £10,000 invested in the US stock market 10 years ago would be worth £42,248 now, compared to £18,186 from the UK stock market. £10,000 invested in the US 20 years ago would now be worth £106,445 compared to £39,293 if invested in the UK stock market.
Source: Morningstar to 31/10/2024
“The performance figures demonstrate that many of the misgivings towards the UK stock market can actually be laid at the door of US exceptionalism, rather than British declinism. The UK stock market has returned an annual 6.2% over the last 10 years, which doesn’t count as a vintage performance, but still leaves investors 3% a year ahead of inflation. It’s also not a million miles behind the European market which has returned 7% a year over the same period (in local currency terms). But the performance of the UK stock market is really thrown in the shade when you consider the US has returned 13% a year over the last decade, more than double the annualised return mustered by UK stocks.
“Weak sterling must also bear some of the responsibility for the wedge between investors’ experience of investing in the US versus the domestic market. UK investors have actually experienced a 15.5% annualised return from the S&P 500 over the last decade, leaving the 6.2% achieved by the FTSE All Share looking even more pedestrian. Little wonder that investors have been pulling out of UK funds and ploughing their money US funds, and also into Global funds which have a high exposure to the US, thereby posting exceptional performance too. Since the beginning of 2015, retail investors have pumped £8.5 billion into US funds, £32.2 billion into Global funds, and have withdrawn £54.7 billion from UK funds, according to Investment Association data.
(Source for performance data: Morningstar to 31/10/2024).
Valuations have only been higher in the dotcom bubble
“The US stock market has been on a sustained and rewarding winning streak, but investors need to be wary of chasing past performance. Buying what has gone up has been a winning strategy for a long time, but history tells us when market trends change, they can do so with a vengeance.
“The US is undoubtedly home to some of the most profitable companies in the world, most notably in the technology sector, and despite their mammoth size, these firms are still churning out exceptional levels of growth. The AI boom has added another leg to the US stock market, and though not everyone is a believer, enough investors have bought into the artificial intelligence story to propel share prices in the US technology sector even further into the stratosphere.
“The expected growth trajectory of the Magnificent Seven means lofty valuations are attached to the shares of these companies. So far the tech titans have delivered on their promise, leaving the doubters choking on their words of disapproval. But high valuations mean a considerable amount of good news about the future is already in the price. Valuations also stand at a concerning juncture from an historical perspective, as the chart below shows.
Source: Shiller Data
“The cyclically adjusted price earnings (CAPE) ratio is a widely used measure of stock market valuation produced and devised by the Nobel laureate economist Robert Shiller. It’s similar to a normal PE ratio except rather than looking at one year of earnings, it looks at the last 10, to give a longer-term perspective. The CAPE ratio for the US stock market currently sits at 36. It has only been higher twice before. Once during 2021 at the peak of the pandemic tech frenzy, which is clearly adjacent, if not part of, the current market environment. In data stretching back to the nineteenth century, the only other time the CAPE ratio has been higher is during the dotcom boom. That didn’t end well for investors who bought into the biggest and brightest companies on the market.
“Clearly this will ring alarm bells for value investors and those who believe in mean reversion in markets. However this signal has been flashing red for some time, and though there was a market correction in 2022, the S&P 500 is now around 20% higher than before the sell-off. The US bulls have therefore continued to have things their way despite historically high valuations. This leaves investors in a quandary with regard to the US. Should they take on the risk of high valuations, or potentially miss out on stellar growth from the most influential market in the world?
Managing concentration risk
“To maintain a diversified portfolio, investors shouldn’t entirely ignore the US, but they should perhaps be mindful of the concentration risk that has built up as a result of the narrow market leadership of a few stocks. Currently 73% of the MSCI World Index is invested in the US. That means global tracker funds are increasingly becoming US tracker funds, with 22% of the typical global tracker fund invested in the Magnificent Seven. This rises to 31% of an S&P 500 tracker fund and 43% if you’ve really pushed the technology trade button and plumped for a Nasdaq 100 tracker. These are relatively high weightings to individual stocks, and the risk is amplified by the US tech titans sharing overlapping characteristics and investment cases.
“Investors who simply want to follow the global market and who will be disappointed if they underperform the MSCI World Index can buy a global tracker provided they are willing to accept the concentration risk at a regional, sector, and stock level. That means being willing to accept that absolute returns will suffer if the US tech trade unwinds.
“Investors who wish to dial down US exposure need to take a more active approach. This can be done by blending US and global tracker funds with passive funds tracking other markets such as the UK, Europe, Japan and Emerging markets. By dialling down US exposure and dialling up other regions, investors can achieve a portfolio that balances risks better. However, should the Magnificent Seven continue to lead market performance, this strategy can be expected to underperform a global tracker, though it may still deliver positive absolute returns.
“Another option for investors who wish to reduce exposure to the US and/or the US technology sector is to select active funds which are underweight these areas. Given the high concentration of US technology stocks in benchmark indices, plenty of active funds in the Global and US sectors will find themselves underweight.
“However, these sectors have not been happy hunting grounds for active managers. Only 22% of active US funds and 19% of active Global funds outperformed a passive alternative compared to the latest Manager versus Machine report. This might understandably put investors off choosing an active fund in these sectors, but a big factor which explains why so few active funds have outperformed an index tracker is their lower exposure to the US technology sector. Should this market trend go into reverse, active managers would be expected to post a better showing as a group. Active Global and US funds therefore can act as a bit of a hedge against the Magnificent Seven falling off their perch, while diluting the concentration risk of passive funds in a portfolio.”
