US shares are the most expensive in the world relative to profits but that does not mean they are about to crash. Sam Benstead explains why.
The American stock market has been on a blistering run for the past 20 years, having doubled the return of British stocks in making investors more than 400%.
Much of this outperformance came in the past decade, as the US tech giants began to dominate online advertising, e-commerce, software, and cloud computing.
As such, £10,000 invested in an S&P 500 tracker in 2012, which mirrors the up and down movements of the index, would now be worth £42,600. The same amount in the UK market would be worth just £18,500. A global index fund would be worth about £30,000, but that strong performance had a big helping hand due to its high weighting to US shares, currently at 68%.
However, the stellar run has been built on sand, according to famed investor Jeremy Grantham, who is co-founder of American asset manager GMO. Grantham, who called the dot-com crash and financial crisis, says the US stock market is in a “superbubble” – the fourth ever after the 1920s, 1990s and Japan in the 1980s. He argues this points to a dramatic downturn in share prices.
Grantham said in January: “The checklist for a superbubble running through its phases is now complete and the wild rumpus can begin at any time.”
He cites a decade of ultra-low interest rates, the dominance of just a few companies in the US market, the sharp rise in share prices since March 2020 and pockets of speculation, from the meme-stock craze to the rise of cryptocurrencies, as signs of a superbubble.
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The S&P 500 index of America’s largest companies has a price-to-earnings ratio of 21 compared with just 13 for the FTSE 100 index of the UK’s biggest companies.
Overvalued, rather than a superbubble
However, investors should not panic and sell shares just yet as the debate on US stock market valuations is far more nuanced.
Rupert Thompson, chief investment officer at wealth manager Kingswood, notes that while valuations of US shares relative to earnings make the market appear very expensive, bonds, which are the main alternative to shares, are not very appealing. This therefore helps justify high stock prices.
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Thompson said: “Investors must look at shares relative to bonds. Bonds have lower yields than the inflation rate so they are not a good alternative to stocks.”
His preferred method of valuation is to look at how expensive US shares are versus other stock markets.
“Compared with global shares, US companies are at a 60% premium relative to their earnings. While US stocks should be more expensive because of their impressive tech companies, the 10-year average premium is more like 30%.
“This premium began to widen in 2021, which makes it harder to justify. In our view, the US market is substantially overvalued, but it is not in a superbubble.”
Thompson therefore finds Grantham’s view to be too extreme and does not expect the market to collapse as it did after the 1929 Wall Street Crash or 2008 financial crisis.
US valuations are now cheaper than before the pandemic
Andrzej Pioch, multi-asset fund manager at Legal & General Investment Management, was more positive on the US market, particularly considering its 10% drop so far this year.
“We don’t believe the market is in a bubble, especially after the recent sell-off. The S&P 500 now has a price-to-earnings ratio of about 20, which is less than before the pandemic,” he said.
Pioch had been buying into the weakness in US shares before Russia’s invasion of Ukraine. He purchased passive funds that target niche parts of the market, such as stocks using artificial intelligence.
“We don’t just chase returns from the largest companies,” he said.
While Grantham points to stock market exuberance during the first year of the pandemic, Pioch notes that the work-from-home stocks bubble, which was most clearly shown by the 400% rise in Zoom Video Communications (NASDAQ:ZM) shares in 2020, had already deflated.
He said: “Sentiment is not overly optimistic at the moment and last year we saw the end of the outsized returns from the pandemic winners.”
Thompson adds: “We have passed the bubble in speculative tech, and there could be more falls to come. It is hard to see these stocks reclaiming their previous highs in an environment when central banks are raising interest rates.”
The chief investment officer is not negative on all tech firms, arguing that the biggest tech stocks will continue to deliver.
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He said: “Microsoft (NASDAQ:MSFT), Alphabet (NASDAQ:GOOGL) and Apple (NASDAQ:AAPL) are not going to face massive competition and customers will not stop using their services in a recession, so they also act as defensive stocks.”
Pioch adds: “Rising bond yields, caused by investors selling bonds due to higher inflation, has historically gone hand in hand with rising stock market prices. Inflation is therefore not necessarily bad for technology stocks.”
US smaller company funds favoured
During this uncertain period, Thompson is buying smaller US stocks, such as those owned by Dodge & Cox Worldwide US Stock fund and the Artemis US Smaller Companies fund. He also owns Polar Capital Global Technology and Sanlam Artificial Intelligence in client portfolios, which own large companies.
Thompson is also backing UK shares. “They are the opposite to American shares at the moment as they are cheap. The shift from growth to value stocks has helped the UK market as it is packed with banks, energy and mining firms. The FTSE is still extremely cheap relative to its history,” he said.
Grantham, however, suggests investors avoid the US stock market completely and buy cheaper “value” shares in emerging markets and Japan. He adds that having cash on hand to be ready to pick up bargains and owning natural resources firms to protect against inflation, as well as gold and silver, is also sensible.
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