America First

In the US, equities are hitting dizzying heights. Indices are achieving new records, whilst their performance and valuation level seem to have relegated indices in the rest of the world to the deepest troughs.

This process is so complete that it’s no exaggeration to say that equity valuations are approaching levels comparable to the 8,000 metres feared by mountaineers in the Himalayas. This altitude – also called the “death zone” – symbolises the frontier after which the human body deteriorates irreparably for lack of sufficient oxygen.

Undoubtedly, US equities are expensive in valuation terms, in comparison to their own historical levels, to equities in the rest of the world, and to other asset classes. A few figures speak volumes. The difference in valuation between US and European equities has never been so great. Today, European equities are trading at a 40% discount on the basis of the one-year forecast price-to-earnings ratio or PER. If we correct this for the sectoral biases of the indices, the discount is still over 30%. In other words, investors are prepared to pay USD 22.5 for USD 1 of earnings on US stocks in the coming year, whereas for a company listed on the other side of the Atlantic, they would have to pay just USD 13.5. Based on seven different valuation ratios, the S&P 500 has been more highly valued only 6% of the time since 1976. Lastly, versus sovereign bonds or corporate bonds, US equities look equally unattractive, particularly as, on the face of it, their intrinsic risk is higher.

It therefore follows that investors cannot be counting purely on valuation as a reliable indicator over a horizon of a couple of months or quarters. Just as mountaineers can rely on oxygen bottles to offset the effects of high altitude, so the stock market indices may be able to extend their stay above 8,000 metres. But stock market history does show that tropospheric valuations are a reliable indicator, in the long term, of poor returns to come. Since 1933, whenever the cyclically adjusted price-to-earnings ratio or CAPE calculated by Nobel laureate Robert Shiller has exceeded the threshold of 34x, stock market performance has never been significantly positive five years later. And most often it has been clearly negative.

Final version of 22 November 2024 – Clément Inbona, Fund Manager, LFDE