Are US equities overvalued, overhyped, over-owned and overdue a correction?
To the first point, Garry White, chief investment commentator at Charles Stanley, believes US equity valuations are “pretty rich”.
“The S&P 500 is trading at a forward price-earnings ratio of 22x, which is elevated by historical standards and higher than when Donald Trump first took office in 2017,” he said.
“Current consensus forecasts predict a 14% increase in US corporate earnings in 2025, outpacing most other regions in terms of growth, return on equity and net debt levels.”
Having said that, Trump’s vaunted tax cuts and deregulation coupled with interest rate cuts could help prop up valuations at their current levels, White conceded.
Vanguard global chief economist Joe Davis went further: “In aggregate, US stock prices are roughly 45% above the top of what I consider to be their fair-value trading range.
“I would view stocks as overvalued even if we knew with certainty that artificial intelligence (AI) – the probable cause of investors’ recent enthusiasm – will ultimately transform every facet of human life, delivering economic benefits on par with the advent of electricity.
“In the US technology and communication services sectors, share prices are inexplicably high relative to expected rates of corporate profit growth. Since ChatGPT launched to the public on 30 November 2022, the average stock in both sectors has nearly doubled in price.”
Depending on the valuation metrics used, mega-cap tech stocks are anywhere from 80% more expensive than the rest of the market (judging by their price-to-trailing earnings ratios) to more than four times as expensive (price-to-sales), he said.
As for whether US equities are over-owned, they now make up 73.9% of the MSCI World index. As a consequence, investors buying passive funds tracking the MSCI World now have the majority of their money in the US – as do many actively managed global equity funds.
White said: “This index is supposed to be a benchmark that reflects the state of the global economy. Instead, an investment in the MSCI World index is really an investment in the major Western technology companies.”
An argument can therefore be made that US equities are indeed over-owned, overvalued and overhyped, so is the market on the cusp of a correction?
No-one knows for sure, but outsized overvaluations and corrections usually coincide with transformative technological changes, Davis pointed out, such as the recent advances in AI or the dot-com boom of the late 1990s.
“Investors grow euphoric early on, then suffer disappointment when the new technology’s vast potential is not more quickly realised,” he said.
If the US equity market – and mega-cap tech stocks in particular – undergo a correction, that might not be such as a terrible thing. It could even be healthy, said White.
“When equity indices rise steadily for an extended period, a market correction can be viewed as a healthy pullback before the market index continues its uptrend. These market corrections can help readjust the valuation of asset prices that have become unsustainably high,” he explained.
“Market corrections tend to be short-lived, with the average market correction lasting about four months.”
Market timing is notoriously difficult and it is impossible to say with certainty which direction tech stocks will head next year.
But one thing that White is convinced of is that earnings growth will be a key driver of returns in 2025, given how high valuations have already run up.
“Earnings reports will become extremely important in determining the direction of individual companies and the market as a whole. Earnings misses are likely to be punished hard,” he concluded.
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