The US stock market and technology related sectors have fueled the current equity bull market and feature heavily in most major indices. These market segments are trading at extended valuation levels with some observers suggesting a downturn is inevitable, sooner rather than later. What can history teach us, and how can institutional investors avoid repeating errors of the past?
Since its March 2009 trough global equity markets have rebounded strongly, gaining almost 500%. The period has been highly accommodating for equities, where stocks with high exposure to growth, momentum, and size risk factors have outperformed. This bull market has also coincided with the exponential rise of indexing. Inflows have mostly been allocated to traditional market capitalisation-weighted (MCAP) indices. According to data from Morningstar Direct, assets invested in index funds and ETFs rose from c.a. US$2tn in 2009 to more than $15tn currently.
High concentration risk
MCAP indices are, by construction, tilted to the above mentioned strongly performing risk factors and currently exhibit a very high concentration risk. The dynamics of MCAP indices trigger a compounding process whereby the inflow of assets inflate the price of stocks exhibiting these risk factors, irrespective of underlying fundamentals. The US stock market currently accounts for an historically high weight of almost 70% in the MSCI World index, and technology-related sectors represent more than 50% of the S&P 500 index.
As a consequence of the strong demand for these market segments, valuation levels are frothy. According to Barclays’ CAPE (cyclically-adjusted PE) ratio, the US stock market is trading at a 60% premium relative to its European equivalent. Today’s Shiller PE for the US stock market of 38 - implying investors only demand a meagre risk premium of 2.6% for taking on US equity risk - was only exceeded at the height of the TMT bubble in 1999-2000. In light of such exuberance, it is necessary for investors to question how long current trends will prevail.
What can history teach us?
By studying history and putting current market data into historical context we identified three lessons from the past to help asset owners determine their portfolio allocations:
1. Although valuation levels often don’t matter short-term, long-term they give strong guidance regarding future returns.
2. Performance is cyclical and often driven by a strong narrative.
3. Diversifying across countries, sectors and risk factors pays off long-term.
We believe it is vital for investors to scrutinise their equity portfolios and address questions such as what impact current high valuation ratios will have on future returns and what level of concentration risk they want to be exposed to. History has shown that a high degree of concentration risk can result in strong performance over certain time periods, the latest bull market being one. Yet, empirics have established that no single region, country, sector or risk factor is superior in all market environments.
Increasingly, investors are moving away from a one-size-fits-all approach such as MCAP indices. Instead, they are customising equity portfolios that are fully aligned with individual investment and ESG policies, as well as return expectations.