How much is too much when it comes to US equity valuations? 
It’s a question that’s been hanging around markets for a number of years now, but it remains as important as ever given the ramifications it has for everyone, regardless of whether you are a large global institution or a mass-market retail investor.
My personal view is that the US stock market still looks expensive as an investment opportunity. But as it represents the world’s largest economy and we are now in the midst of a presidential election cycle, ignoring it completely or divesting is probably not the right move.
The statistics behind valuations in the US are powerful. Figures from Bank of America Merrill Lynch show US equities are currently operating at a 70-year high versus Europe, with significant outperformance in the past decade alone. The S&P 500 has only recently hit its record high in January 2020, while the index has returned 275.6 per cent in the past decade.
But beyond the figures, the fact is that the market continues to defy expectations. Many commentators, including myself, believed the market could simply not sustain these returns, yet it posted the strongest outperformance of any major market in 2019, returning almost 24 per cent to investors.
The pessimists would point to history as their rationale for expecting the worst. I remember reading once that Warren Buffett’s preferred methodology is to look at the value of the US stock market to the value of GDP. Based on that calculation the US market is at 158 per cent of GDP today. That’s similar, if not higher, than the peak of the tech bubble.
Concentration levels within the S&P 500 are also reaching historic extremes, with the five largest stocks now accounting for 18 per cent for the index – again matching the levels seen just prior to the tech bubble in 2000.
The optimist would tell you to largely forget about history. The argument there would be that valuations are high because bond yields are low. Rates were cut three times in 2019 and are unlikely to rise any time soon (indeed if Donald Trump had his way, I think they’d fall even further). They’d also point to these strong returns coming amid a backdrop of political uncertainty between the US and China, something which has subsided to a degree recently following the recent ‘phase one’ trade agreement.
Does tech dominance shroud other opportunities? 
A lot of the aforementioned facts about the outperformance in the index and the biggest contributors to that outperformance lead us towards the technology sector and the FAANGs (Facebook, Amazon, Apple, Netflix and Google). A recent chart I saw from Saracen fund management which showed these five companies have collectively grown more than 350 per cent in the past five years, compared to just over 150 per cent for the S&P 500 on the whole. Take those five out (and a few other mega caps) and maybe we would not be talking about bubble territory in the US any more?
These are good companies with bright prospects, as Saracen points out three of them now have a market cap of $1trn with Amazon not far away. But this is now heavily priced in and who’s to say if other competitors, new technology or regulation could change the fortunes of these businesses in the future. Those who are forgetting their sell discipline are undoubtedly taking a risk. There is also a distinct lack of dividends on offer from the quintet.
So, what should investors expect after another strong year in the US? Goldman Sachs says there is a strong case for staying invested given that historically, when the S&P has delivered over 30 per cent over a one-year period, 85 per cent of the time the subsequent year also saw positive returns.
As I said earlier, the US is expensive, but given it accounts for roughly a quarter of global GDP, it is simply too big to ignore. Those looking for access may want to consider those funds with more of a small- or mid-cap bias, such as the LF Miton US Opportunities fund, a 35-45 stock portfolio, which typically consists of a greater proportion of medium-sized companies and smaller large companies than its peers.
Another alternative is the Schroder US Mid Cap fund, managed by Bob Kaynor. To diversify this portfolio, the team has three sources of stock returns. 'Steady eddies' or less cyclically sensitive stocks act as ballast in the portfolio, 'Mispriced growth' are stocks where Bob feels the market has not fully understood the company's earnings potential, while the last, and smallest bucket, is ‘recovery-type’ situations.
A third alternative is the Hermes US SMID Equity fund. Lead manager Mark Sherlock and co-manager Michael Russell look for quality businesses with minimum debt, in industries with barriers to entry, or that provide products or services that cannot easily be replicated. The result is a fund that has historically fallen less than its index in down markets.
Darius McDermott is managing director at FundCalibre. The views expressed above are his own and should not be taken as investment advice.