Market Synopsis – July 2023
The overvaluation of US equity markets
The US equity market accounts for over 60% of global equity markets by capitalisation and has proven to be an important driver of global markets over the past decade. In June’s Market Synopsis, we explained how, in our view,the long-term decline in US interest rates and corporate taxes had led to the overvaluation of US equities. This month we will take a deeper look at various indicators that illustrate just how overvalued the US is, and why the overvaluation could persist in the near term.
What the metrics say
Figure 1 includes several standardised metrics ranging from earnings-based multiples to market capitalisation measures. All of which are based on S&P 500 data stretching back to 1955. The first panel depicts the commonly used price-to-earnings (“P/E”) ratio and indicates that the US equity index is overvalued. To smooth out the cyclical nature of earnings, the 10-year moving average trailing reported earnings-based P/E ratio is included. This ratio also points to an overvaluation. As investors typically invest with the expectation of growth in future earnings, a growth-adjusted P/E ratio is also relevant. Regardless of the earnings-based multiple used, one message remains true, the S&P 500 appears over valued.
Figure 1 – US equities are overvalued
To provide a different angle, we assess the price-to-sales (“P/S”) ratio which removes the impact of shifting profit margins. The P/S ratio illustrates that, excluding the pandemic, the S&P 500 has not been this overvalued since the dot-com bubble. Finally, panel 5 illustrates that unless the listed corporate sector was taking an ever-rising share of the economy, there is no reason why the market capitalisation of the S&P 500 should increase its share of the economy over time. Further evidence of the overshoot in US equity valuations.
It is not just US tech that is overvalued
It is evident that US equities are overvalued, but maybe this overvaluation can be justified by superior fundamentals. In fact, the return-on-equity (“ROE”) of US companies is almost seven per cent higher than their global ex-US peers. So it makes sense that US markets should trade at a premium. However, even considering the relative ROE advantage, US equities are still 30% overvalued versus global ex-US equity.
Figure 2 – Growth shares are especially expensive
Another point of view could be that US indices appear expensive because they tend to be overweight growth shares. Given that growth shares trade at higher valuations than value shares maybe this could be the reason US indices appear so overvalued? Figure 2 on the previous page highlights that even after accounting for the premium typically paid for growth shares they still appear very expensive relative to their value peers. In other words, not only is the US market significantly overweight growth shares, but they are also richly priced. This goes some way to explaining part of what has led to the discrepancy in valuation between US and global exUS shares.
While US markets are overweight growth, and more specifically tech shares, Figure 3, which details the 12-month forward P/E and price-to-book value (“P/B”) ratio for all GICS level 1 sectors, illustrates that the overvaluation is across the board. One might expect this overvaluation for the information technology sector, and even the consumer discretionary, and communication services sectors as they include tech shares too. However, even US sectors without tech exposure such as energy, materials and industrials appear expensive on both an earnings and balance sheet basis when compared to their global ex-US peers.
Figure 3 – Almost all US equity sectors are overvalued
When will US equity markets derate?
While it is clear US markets are overvalued, what is less obvious is when US-listed shares will return to more reasonable valuations. The timeliness of which will depend on how the valuation discrepancy is resolved, which could be one of two ways. Either: global ex-US stocks actively outperform, or we witness the stagnation of US equity markets. However, given the looming 2024 recession, US equities could perversely outperform global ex-US as the USD is a countercyclical currency, and US tech shares could disproportionately benefit when the US Federal Reserve cuts interest rates. Eventually, the US recession will pass, at which point we expect a period of active global ex-US outperformance.
The sustained overvaluation of US equities may sound counterintuitive, but as Figure 4 below depicts, valuations tend to only matter to investment returns over the medium to long-term holding periods. More specifically, Figure 4 depicts how the relationship (as measured by R squared) between valuation and returns gets stronger as the holding period increases. Over a three-year holding period valuation only explains 30% of investment returns, but by 10 years that rises to 80%. In other words, valuation remains vitally important to the long-term investor. Shares do rerate to fair value eventually, whether they are below fair value or above it. At today’s lofty valuations, the US 12-month forward P/E ratio implies a 10-year future total nominal return of just 4.2%. In summation, the returns of long-term investors are intrinsically linked to the valuation of the shares that they purchase.
Figure 4 – Valuation predicts long-term returns
Many currencies are cheap, the USD is not one of them
There are a variety of ways to value a currency, our preferred approach is to rely on the purchasing power parity (“PPP”) model. A PPP model compares the national CPI basket of a country (which includes subgroups such as shelter, health care and transportation) against an equal basket of goods in another country to determine the true exchange rate. The advantage of this method is that the PPP exchange rate tends to be less volatile than the market exchange rate as it does not react to news flow, sentiment or tariffs.
Figure 5 – The Yen and other European currencies are cheap
[/vc_column_text][vc_column_text]Figure 5 presents just how over or undervalued major developed market currencies are based on the PPP approach. The chart makes it clear that the USD is particularly expensive, and historically similar periods of overvaluation have been followed by structural downtrends in the currency. However, given our expectation of a US recession emerging in 2024, we believe the USD will remain well-bid due to its safe haven status. Only once the worst of the recession has been endured, do we believe the USD will begin to structurally weaken. On the other hand, Figure 5 also highlights the undervaluation of several currencies such as the Norwegian krone and even more materially the Japanese Yen.
No matter which way you slice it, US equity markets are overvalued. Typically, this would signal poor future returns for investors. Similarly, and exacerbating the position for a global investor, the USD is as much overvalued as US equity markets. With a recession brewing on the horizon, US equity markets and the USD may be able to sustain their lofty valuations a little while longer as investors rush into safe-haven assets. However, once the recession passes, a period of active outperformance of global ex-US shares is probable. In turn, the patience of the long-term investor that purchases businesses trading below their intrinsic value will be rewarded when the valuations of those businesses return to their fair values.