It’s Different This Time – Or Is It?

U.S. equity index valuations have reached an all-time high

Any student of financial history with a long-term investment horizon would not hesitate to underweight, or even zero weight, the U.S. stock market index.  History says that when valuations are as high as they are today, the equity risk premium disappears and returns over the medium term will be low or negative.

The classic exposition uses the ultra-conservative Shiller CAPE ratios – the price today divided by ten-year average earnings adjusted for inflation.  Thank you to my friends at Ruffer and Investec for some of the data which follows.  The Shiller ratio averaged around 15x between 1870 and 1953 and 23x since then, perhaps reflecting the rise of the cult of the equity.

The highest CAPE ratio achieved during that period has been 45x, reached three times in the 21^st century:  during the dot.com bubble; in 2020 during the COVID period; and now.  At both the previous times there were, albeit for different reasons, little or no earnings to support booming stock market valuations.  Valuations are back at these levels now, though skewed heavily by big tech – with the MAG7 now around 35% of the U.S. index and trading at an average CAPE ratio of over 60x.

Do you believe that this time something is different?

Why does this matter?  Because historical data – with a high level of predictive power - suggests ten-year stock market returns from this valuation level have been approximately zero.  So, if history repeats itself, the market will at best go sideways over the next ten years.  Anybody investing in the U.S. today must be expecting another outcome on the basis that something is different this time.

It could be that the monopolistic positions of large tech companies continue to push their earnings ahead.  There are few alternatives to Amazon (though personally I try), Google, Meta, or Microsoft.  I’ve noticed 20 to 30% increases in charges from some of these players over the past year.

The trouble with that is that if I pay more for Google or Microsoft’s products, I have less to spend elsewhere.  At some point I’m going to be sufficiently unhappy that I will vote politicians in who will find a way to cap price increases.  So a different case really relies on big tech being more powerful than politicians.  The past tells me that it is unlikely to unfold in this way, but maybe it is different this time round.

Alternatively, there is a legitimate argument that we are back in a world of Quantitative Easing.  It is not quite the same as the 2008-2020 period, because it is being driven by governments, and not central banks.  But the outcome is the same – the response to any problems is to push more liquidity into the world’s financial system.  In a world of low growth, a fair part of that will find its way to financial assets and push prices up.

The trouble with this is that it cannot go on for ever.  If asset inflation increases, so do the political stresses.  Going to the magic money-tree must eventually lead to significantly higher inflation. At some point either the bond-markets or voters will step in to force change, unless – again - it really is different this time. 

If not, the case for diversifying away from the U.S is hard to contest

On the assumption that it is not, investors should be wary of the U.S. stock market, and by implication global markets – because the U.S. accounts for 73% of the Developed World index.  Apart from the valuation argument, there is also a significant concentration risk in both the U.S. and the global index.

Perhaps investors continue to allocate to the U.S., not because they necessarily believe that this time is different, but because it is hard to make a case for other markets, despite their relative cheapness.  Europe and the U.K.’s productivity has flat-lined since 2018, whereas the U.S. has grown by 18% during the same time.  China’s economic growth is clearly slowing and there is a risk they fall into the same deflationary trap as Japan did in the 1990s.  Japan and Korea both suffer from the world’s least appealing demographics, with growing shortages of workers.

In my view, the imperative of diversifying away from the U.S. trumps all these considerations, and global investors either need to invest in a manager who is prepared to go a long way off bench-mark, with the attendant risks of underperformance in the short-term, or they need to diversify their own benchmark away from the U.S.

Japanese stocks have many attractions

There are many reasons why Japanese stocks, for example, look attractive.  At the most fundamental level, Japan Inc has a wide range of top-class companies in most industries and an educated and diligent workforce.  Corporate governance has improved substantially following the changes of Abenomics, and it is no longer possible for even the most backward company to ignore shareholders.   

There is still much further to go and the new Prime Minister, Sanae Takaichi, sees herself as the successor to Abe’s reforms.  There is still opposition in some corners, most notably the Ministry of Finance, but she is popular in the country and has the best chance of seeing further reforms through.  The Tokyo Stock Exchange has also made some important moves, threatening to de-list companies who are unable to raise their Price to Book above one.

At a financial level, Japanese accounting is more conservative than the U.S. and corporate leverage is at a low level.  But the most important reasons to look at Japan now are both to do with markets.  One is the sheer cheapness of listed stocks, because of the weakness in the yen, which is now trading at levels last seen 40 years ago and on purchasing power parity base has never been this cheap.  There is no guarantee what will catalyse a change of direction in the yen or when, but happen it will.

The second reason is the role of private equity, a relatively new force in Japan, to act as a catalyst to force valuations up.  The take-over rules changed in 2023, and we have since seen a steady stream of acquisition activity among small and mid-size companies.  From a PE perspective, there is a wide range of potential opportunities amongst high quality and largely unleveraged companies.  Moreover, the assets are cheap in US$ terms and the cost of leverage is far lower than anywhere else.  The big change to come is likely to be that large companies will come into scope too.

Other non-US markets are even cheaper

I use Japan as an example, as I travel there regularly as part of my relationship with Arcus Investments, the Japanese manager.  In fact, I am writing this article from a post-industrial town in Niigata-ken’s snow country – and yes, it is snowing.   

While relative to its own history the Japanese stock-market’s Shiller CAPE ratio is trading very cheaply, in absolute terms it is more highly valued than many other non-U.S. stock markets.  This perhaps reflects the fact that it is one of the few stock markets with substantial high-end manufacturing and tech companies – or that Japan inflated its own bubble in the 1980s, thereby skewing the data.   

Emerging markets, the U.K., and China all trade significantly cheaper in absolute terms and like Japan they are at the bottom of their historical ranges.  But wherever your preference is, unless you really believe that history is going to take a different course, the main point is to diversify away from the U.S.