Warning: Share market close to all-time high. What to do…

The stock market has kicked off the year on a positive note, reaching record highs in the US. While this may initially appear promising, it’s essential to consider potential risks that investors need to be mindful of. On the flip side, I identify promising investment opportunities amidst these considerations. 

Past performance should guide decision-making  

The table provided below outlines the medium-term index returns for different geographical stock markets. 

To provide context, stock markets have shown an average annual return of approximately 10% over the last four decades.  

Further, Japan and the US have exhibited stronger performance over the most recent decade. These two countries constitute over 76% of the global index, which has contributed to its outperformance. 

Conversely, Australia, Europe, emerging markets, and the UK have all underperformed.  

This high-level analysis indicates that investors aiming to capitalise on mean reversion may consider decreasing their exposure to the US and Japanese markets and, in turn, increasing exposure to the recently underperforming markets.  

It’s important to note that a conventional allocation to emerging markets would typically not exceed 5% of a total portfolio, as emerging markets tend to have a higher risk/volatility profile.  

However, we must dig a little deeper than this.  

Is the US stock market overvalued?  

The CAPE ratio serves as a reliable predictor of future 10-year returns, boasting a correlation of approximately 80% with actual subsequent returns. While not flawless, it serves as a valuable indicator.  

Currently, the US CAPE ratio is almost 34, marking the second-highest level in over 150 years. This implies that the US market is currently overvalued, which tells us that the future 10-year returns are likely to be below average as valuation multiples eventually revert to their mean.  

The S&P 500 index is trading on a PE ratio of over 27 times. The long-term average since 1871 is 16 times. Again, this measure suggests that the US market is over-valued.  

However, it’s not the whole market. It’s the Magnificent 7 stocks that have driven the share market higher. The Magnificent 7 includes Microsoft, Apple, NVIDIA, Amazon, Meta, Google, and Tesla. These companies are trading on a weighted average PE of 44 times – almost 3 times the market’s long-term average!  

The US mid-cap index is trading on a PE of less than 15 times and the equal weight index is trading at around 17 times.  

Concentration risk is problematic  

The “Magnificent 7” companies are collectively worth more than USD 13 trillion. Except for Tesla, any of the remaining six companies individually is worth more than the entire Australian stock market. Astonishingly, these seven companies collectively exceed the combined value of the UK, Japanese, and Canadian stock markets.  

The Magnificent 7 constitutes over 30% of the S&P 500 index and nearly 20% of the MSCI Global index, posing a significant concentration risk. 

While you may think these companies are formidable and likely to maintain their dominance, especially considering anticipated benefits from advancements in AI, a chart from Research Affiliates indicates that the top 10 global businesses can undergo significant changes from one decade to the next. Additionally, it is arguable that any potential growth upside is fully reflected in current valuation levels. These companies are expensive relative to the rest of the market.   

Japanese market has rallied since Covid  

The Japanese index (Nikkei 225) has rallied just as much as the S&P 500 index since the beginning of COVID-19 and is now trading on a PE of around 20 times, which is well above its long-term average of around 14 times. It has a similar concentration risk as the US market with the top 10 companies accounting for over 37% of the index. The top 17 companies account for over half of the index.  

Growth companies have weathered higher interest rates  

Conventional wisdom suggests there should be an inverse relationship between interest rates and growth company valuations. These companies often carry substantial debt to fuel their growth and may not generate positive cash flow. Consequently, elevated interest rates contribute to increased cash outflows through interest costs, exerting a negative impact on their overall valuation.  

Furthermore, interest rates influence company valuations by raising the hurdle of the risk-free rate. This implies that companies must achieve higher returns on equity to compensate investors for their heightened risk. 

Despite this conventional expectation, higher interest rates have not significantly affected stock market valuations. One contributing factor is that many companies have maintained profitability even in the face of higher interest rates. Halfway through the fourth quarter earnings season, 72% of S&P 500 companies have reported higher than expected earnings which is only a smidgen below the average of 75%, thanks to the robustness and resilience of the US economy.  

If interest rates remain higher for longer, investors must consider how long companies can sustain their current earnings levels. 

Future expected returns  

The table below sets out future expected 10-year returns in AUD on an unhedged basis using the Research Affiliates proprietary model. Hedged investment returns are likely to be 0.5 to 1.0% p.a. higher given the AUD is trading below the long-term level of circa 70 US cents.  

Future expected returns are influenced by projected (1) dividends, (2) inflation, (3) earnings growth, (4) foreign exchange and (5) change in valuation multiples.  

What to do… 

To give you an example of how we have addressed the risks and opportunities discussed above, we have incorporated the following approaches when investing client monies.   

• Most clients have 40% or more of their total portfolio invested in the Australian market. We use a combination of traditional market cap indexing (A200), mid-cap indexing (EX20), fundamental indexing (QOZ), small companies (VSO), and Dimensional indexing (DACE) amongst other things.  
• We like to incorporate greater exposure to ex-US markets (such as VEU and HEUR).  
• To accommodate the valuation concerns we have in the US market, we use a variety of approaches such as quality factor indexes (such as HQLT and QHAL), valuation overlays (such as VVLU and DFGH), and equal weight indexing in the US (QUS).  
• Where possible we incorporate sustainable investment options, as these companies are likely to attract a greater share of capital market flows.  
• Over the past few years, we have been accumulating exposure in emerging markets using a variety of indexes and active funds. Emerging market investments constitute a small portion of a portfolio.  

Evidence-based approach  

An overwhelming body of evidence supports the idea that directing investments toward geographical markets that exhibit opportunities to provide above-average returns, using low-cost, rules-based indexing methodologies, has a high likelihood of maximising long-term returns. This evidence-based approach allows investors to maximise returns whilst minimising investment risk.