Why we are underweight US equities – Corion Capital

*This content is brought to you by Corion Capital 

By David Bacher*

Although one should always treat a client as a ‘king or queen’, at Corion we do not live by the view that the client is always right. In fact, we see it as our role to gently point out where we disagree with a client, irrespective of whether or not it is a message that the client wants to hear. These conversations are difficult; they often lead to missed business opportunities in the short term.

These days, many clients express a desire to have most of their equity savings invested in the United States (US). Going forward, we think this could be to their detriment. We suspect that the main motivation our clients have for wanting this is the reliance they have placed on the exceptional recent returns in the US, coupled with the countless media articles (sometimes self-serving), focusing on the risks of being invested in South Africa.

At the risk of not winning any popularity contests, we have listed the primary reasons why we currently maintain an underweight position to US equities.

• Valuations relative to its history

The price to earnings ratio, which is probably the most frequently used valuation metric on the S&P 500 Index, has increased from approximately 14 in the early 1980s to a current ratio of 26.5. These are historic earnings.

When looking at other commonly used valuation metrics, such as price-to-book and the dividend yield, we arrive at a similar conclusion. Investors are currently paying a lot more for future earnings relative to history.

• Valuations relative to other regions

Admittedly, the US equity market has for years been more expensive than most other regions. It is blessed with an abundance of highly skilled employees and entrepreneurs, a highly sophisticated financial system and access to one of the biggest consumer markets in the world.

It is, therefore, too simplistic for investors to adopt a stance of avoiding the US because it is more expensive. Rather, investors should ask whether this valuation premium will continue to exist going forward.

Using forward earnings, as shown below, the US trades at a 42% valuation premium relative to Europe (22.4 vs. 15.5) and a massive 130% relative to South Africa (22.4 vs. 9.7). Given that these valuation gaps are the highest they have been in 20 years, we believe that the risks are to the downside.

• The closing of the liquidity taps

The US Federal Reserve has been materially increasing liquidity since the 2007-2008 global financial crisis. This surge in liquidity has found its way into risk assets and consequently to increased prices of such. The bond yields remain at historical lows, whereas the S&P 500 keeps on finding new highs. The Federal Reserve has begun signalling that it will start reducing money supply, putting a potential end to the avalanche of cash that has to date been looking for a home.

• Index composition

The composition of the S&P 500 is such that the technology sector accounts for approximately 25% of the Index. As expected, technology has been by far the best performing sector over the last 10 years.

The technology sector has delivered an annualised return of more than 21% over this period, approximately double the return of the broader S&P 500. In turn, the five largest shares (Apple, Microsoft, Amazon, Alphabet and Tesla) in the Index comprise more than a fifth of the Index. All of these named shares have rallied significantly and are arguably on very stretched valuations. In addition, it is these large tech-enabled corporations that, in an increasingly divided world, could be ripe for more regulatory and anti-trust interventions.

• Inflation

Inflation in the US has continued to raise its head. The Federal Reserve chairman has recently acknowledged that the current inflation experienced in the US might be more persistent than initially thought. The monetary policy to deal with the rising inflation is likely to lead to higher interest rates, which in turn, have historically negatively affected equity valuations through an increased cost of capital.

Don’t get us wrong. The US makes up a large portion of the investable universe and it is likely we will always have some exposure to this market. However, for the reasons stated above, it is our view that it is not the right time to be rushing to invest in US equities.

• David Bacher is the Chief Investment Officer of Corion Capital (an Authorised Financial Services Provider). Corion is driven by a desire to simplify the world of investing and manage a broad range of multi-strategy funds. 

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