7 minTo invest or to speculate?
Guy Wagner On the stock markets, the obsession with relative performance has taken on worrying proportions. Rather than rejoicing at a good absolute performance, investors become unhappy when they realise that they have not done as well as some benchmark index that they barely knew existed just a few years ago, but to which they now attribute the infallible science.
All this has a major impact on the behaviour of professional fund managers. Their decisions are now increasingly motivated by the fear of underperforming an index and losing their clients, rather than based on their real convictions. Many managers who claim to be active actually prefer to stay very close to their benchmark index. And as long as these indices are rising, the risks they take in doing so are invisible. In this respect, the current environment resembles that at the beginning of this century.
As a result, we are witnessing a new investment paradigm characterised by fear of missing out on the upside rather than by analysis of fundamentals. While in theory investment decisions are supposed to be made rationally, the democratisation of finance means that in practice they are increasingly made on the basis of emotion. And social networks make this phenomenon even more pronounced. All this raises concerns about the stability of financial markets, which at times resemble casinos, and about the stability of the financial system as a whole.
The importance of passive management only reinforces this. Passive management is largely valuation agnostic, with the aim of buying stocks in proportion to their weighting in an index. And insofar as in many of these indices (starting with the S&P 500), the weight of stocks is determined by their market capitalisation (the number of stocks times the share price), the stocks that have risen the most attract the most capital, leading to a risk of overvaluation, the opposite being true for stocks that have fallen out of favour.
The United States accounts for around 20% of the world's Gross Domestic Product, but the US market represents some 70% of the global index. Such an imbalance has not been seen since the late 1980s, when Japan accounted for less than 10% of GDP but nearly 50% of the world index. The US market has become such an important part of the global index that the main question for an equity investor is whether to overweight or underweight it. And more specifically, whether to overweight or underweight large technology stocks.
Weight of the US market in the world index
Source: Factset, MSCI, Jefferies
The arguments generally put forward in favour of the American market revolve around "American exceptionalism". The idea is that the United States has certain fundamental advantages, such as lower energy costs, a very large domestic market and the fact that it controls the reserve currency and world trade, which means that it has no constraints on financing its deficits. Added to this is the fact that American companies seem to dominate the digital economy. More recently, the election of Donald Trump is expected to bring a new wave of deregulation and tax cuts favourable to the US market.
The fact is, however, that since 2017, the outperformance of the US market has been due to a rise in its valuation and not to significantly higher earnings growth than in other regions (just as higher economic growth in the US is primarily the result of a much higher budget deficit). As a result, on the basis of most valuation ratios, the US market premium is now historically high. Another point to note about the performance of the US market is that it can be explained by a very limited number of stocks . This narrowness can even be seen in the technology sector. Last year's outperformance was based essentially on a single stock: Nvidia.
The outperformance of the US market illustrates the well-known phenomenon that 'markets make the narrative’. The factors behind a rise are used to justify further gains. Technology stocks are a good example. They seemed to be losing their splendour in 2022 before the theme of artificial intelligence breathed new life into them. There is no doubt that the major US technology stocks are, on the whole, very good companies. They have competitive advantages and generate recurring revenue streams and high returns on capital employed. However, they are now very expensive and their earnings growth is starting to slow. It is also worth noting that, with the advent of the cloud and artificial intelligence, these companies are beginning to compete more closely with each other, whereas until now each had a virtual monopoly in its core business.
Numerous examples demonstrate the absurdity of the current situation: the market capitalisation of the 15 largest US companies is almost equivalent to that of the European, Japanese and emerging markets combined; the 27 largest semiconductor companies now have a total market capitalisation that exceeds that of the energy and materials sectors combined; Tesla's market capitalisation has risen by $850 billion in two months, which is as much as the total market capitalisation of the other 10 largest car manufacturers.
The 15 largest US companies represent nearly as much as the European, Japanese and emerging markets combined
Source: Gavekal Research/Macrobond
In 2000, companies like Cisco Systems and Sun Microsystems were trading at more than 10, or even 20, times their sales. Over the following 3 years, their share price fell by 75% to 90%, and Sun's CEO had this to say: "At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Do you realise how ridiculous those basic assumptions are?” Today, the number of stocks trading at more than 10 times sales is once again very high in the semiconductor sector.
It is important to note that buying an index is not necessarily a bad idea. When a market is reasonably valued and you believe in its prospects but don't necessarily have the resources to pick individual stocks, buying the index can be a solution, and a cheap one at that. One example is the Chinese market today. However, there is a close correlation between valuation and long-term performance. And the valuation of the US market is now so high that the return an investor can reasonably expect is particularly low. It has to be said that the high valuation of the US market can be explained by the disproportionate weight of a limited number of stocks. In other words, while the index is expensive, many US stocks are not.
For a bubble to continue, it needs to attract more and more capital. And it is quite possible that passive management will continue to gain market share at the expense of active management. Nevertheless, we see at least 3 risks for the US technology sector, and hence for the market as a whole:
- Potential disappointments surrounding Artificial Intelligence, especially in view of the particularly high level of investment spending by major technology companies in this area.
- A drying up of liquidity. While the markets have benefited from abundant liquidity since the end of 2022, the situation will start to change in 2025 with the need to refinance a large proportion of public and private debt. This is a risk for all markets (at least in the West), but the US market seems to be the most at risk, given that it has benefited most from the increase in liquidity.
- A weaker dollar. The correlation between a rising dollar and the outperformance of US growth stocks is currently very high. However, a strong dollar seems incompatible with the Trump administration's objective of reindustrialising the United States. Donald Trump has said on several occasions that the US currency is overvalued. The current situation resembles that which existed at the start of his first term in office.
USD index 2024-2025 versus USD index 2016-2017
Source: Bloomberg – The Mad King
The combination of an environment that favours equities and expensive stock market indices clearly speaks in favour of active management, even if it is unrealistic to think that such management can sustainably outperform as long as the craze for index management continues. Investors today have a choice between playing the momentum card, with the associated risks, or opting for a strategy based on fundamentals, with the risk of underperforming the indices, at least in the short term.
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