As we see the equities world currently, the economic progress of over the past seven years has caused a significant and unsustainable deviation in valuations. This is no clearer than in the United States. To put this in perspective, since the crisis the total size of the United States economy increase 28.6% while the stock-market has grown 196.5%. This would seem to be an unrepeatable occurrence from current levels.
Markets are addicted to this drug we continue to call ‘stimulus’
Of course, the rear-vision mirror is always clearer than the road in front, and there are multiple reasons validating such a strong result; including initially weak valuations, strong earnings growth relative to the economy, sustained low interest rates, Federal Reserve intervention, falling unemployment and strong profit margins.
However, one of the greater concerns today is that we find ourselves in a position where market participants are addicted to this drug we continue to call ‘stimulus’. These participants cheer on the central banks every time they add more of it – Benjamin Graham would consider it more appropriate to call these people ‘participants’ or ‘speculators’ rather than ‘investors’, but the irony is the central banks are intervening because the economic outlook is grim.
It is a matter of the market rising on good news and rising on bad news. Of course, this is not a sustainable pattern; so one needs to make a decision about whether to seek safety, and thereby accept low or negative real returns, or participate in the exuberance.
At the extremes of the performance spectrum are Italian banks and small cap gold miners. These micro-sectors have produced enormous divergence, with US small company gold miners up 375.3% since the turn of the commodity crash whilst Italian banks are still down 31.9% over the same period.
US Stocks at High Prices
The US market suffers from high prices in many sectors, typically due to a combination a combination of abnormally low earnings yields, low dividend yields and unsupportive profit margins. The fresh record high in the NASDAQ, Dow Jones and S&P500 for the first time since 1999 do not help.
If you aren’t considering holding an underweight position to United States equities now, what catalyst would be required before you did decide to reduce your exposure?
Admittedly, one of the largest problems from a portfolio construction perspective is that the removal of United States equities dramatically limits the investment universe; it is now 59.8% of the global index. This means the United States stock-market is now one and a half times bigger than Europe despite having a similar population and GDP. Indeed, we live in bizarre times.
So what does one do under this scenario? Does one chase yesterday’s winner? Does one ‘go passive’ and accept potentially mediocre returns? Or does one remain strong in a pursuit of maximising the risk-adjusted return in the long-term?
This is the dilemma investor’s face. The well-versed analogy, “if the United States sneezes, the rest of the world catch a cold” is an overused term but admittedly something everybody should consider for portfolio construction. To our judgement, there is a reasonably clear case for United States underperformance and we would prefer to see greater caution among the investing public.
