One of my favourite analysts – Jeremy Grantham of US asset manager GMO – has come out and blasted the rally in the US stockmarket. “I have been completely amazed”, he told CNBC. “This is becoming the fourth real McCoy bubble of my career.”
He even suggested that investors should have “zero” exposure to US stocks.
Grantham has a good, if somewhat bearish, record. So what should investors be doing right now?
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Here are a few reasons why the US stockmarket has done so well
Why is the US market so expensive?
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There are a few clear things that the US market has had in its favour. One factor is that the US market is the one that hosts all of the biggest tech stocks. Tech is currently oligopolistic – so the big players can make outsize profits because competition isn’t anywhere near as brutal as in other sectors.
Another, related factor, is that we’ve been in a “long duration” – or “jam tomorrow” – bubble. Put simply, the lower that interest rates and inflation are, the less difference there is between the value of money today and the value of money in a year’s time, or ten year’s time.
Why does that make a difference? Because (again, this is a simplification, but it cuts to the heart of the matter) the business model for most tech stocks is built on paying a lot of money today for customers who will pay off handsomely in the future.
When the discount rate is very low (ie, profits received ten years from now are worth almost as much as profits received tomorrow), then businesses which spend a lot today but expect to get back an awful lot in the far future, are appealing.
So the tech sector is an important difference that is always brought up. It’s often viewed as a “rational” reason for the US being so expensive. But there are other factors to consider too.
One is that the US market is the first in line to benefit from money printing by the Federal Reserve, America’s central bank. It’s the closest to the big liquidity tap. That sounds simple – and it is – but it’s true.
Secondly, the US is also the market that benefits most from ongoing, relentless, undiscriminating passive index flows. Long story short, for various reasons, if you have a workplace pension in the US then you probably stick a lot of your money every month into an index fund that tracks the S&P 500.
So a small but significant chunk of the earnings of a large number of working Americans is trickling into the S&P 500 like clockwork, every single payday, regardless of valuations or conditions. That’s an advantage no other market in the world has.
Price still matters even if it doesn’t feel like it
What does this all mean in practice for investors? Let's summarise what I’ve just said, then consider whether or not it justifies current valuations and whether it’ll change or not.
The US market benefits from two basic things: it is one of the best-placed markets for today’s environment of low interest rates and low inflation; and it is also the best-placed to benefit from the ceaseless stream of liquidity being pumped into markets around the world.
That helps to explain why it’s so expensive, and why it has been so expensive for such a long time. So will this continue?
Howard Marks of Oaktree Capital put another memo out yesterday (you should seek them out – they’re free, well-written, and not particularly technical). And he sums up the question we’re really asking here quite nicely: “Can the Fed keep buying debt forever, and can its doing so keep asset prices up forever? In short, many investors appeared to conclude that it could.”
The answer to that question is: maybe they’re right. But the second question then is: but what if they’re wrong? Are they offering any concession to the downside? It certainly doesn’t look like it. And that’s where the risk lies.
As Marks puts it, “the fundamental outlook may be positive on balance, but with listed security prices where they are, the odds aren’t in investors’ favour."
So what should an investor do?
Here’s what I’d suggest: don’t stress about the US. Just buy other assets instead. Because we can’t stop paying attention to what goes on in America (and this goes way beyond the stock market, of course), it’s easy for us to fall into the trap of imagining that what happens over there is just a bigger version of what’s happening over here and everywhere else (particularly in developed markets).
In fact, it’s not at all. According to the latest figures helpfully supplied by Duncan Lamont over at Schroders, the UK market is relatively cheap, so is Japan, and so are emerging markets (indeed, emerging markets are Grantham’s top pick right now).
So rather than agonising about whether you want to play chicken with the S&P 500, maybe focus your efforts on markets that are more reasonably valued?
(I’m not saying you should dump all US exposure by the way. I know a lot of you will own Scottish Mortgage, for example, and there have been plenty of times when taking profits on that trust might have looked like a good idea, but then turned out not to be. Market timing is hard. The point is – take a look at which eggs are in which baskets, and consider whether the distribution is wise).
Now some of you will have read my colleague Dominic’s piece of a mere two days ago. You may think we’re contradicting each other. We’re not – it just reflects two different ways of looking at the market.
Based on a simple market-timing strategy (which is all about charts), it’s not yet time to get out of the S&P 500. But based on fundamentals, the S&P has been overvalued for a while, and it’s definitely now time to look for better opportunities elsewhere. Different investors can integrate these approaches in different ways – I’ll expand on that in a future article.
Anyway, Merryn and I discussed all this on our latest podcast, which you can catch up with here. And if you’re looking for ideas for an all-weather, inexpensive, nicely diversified, mostly passive portfolio – we’ve got an update on such a model in the latest issue of MoneyWeek. I suspect it will be of particular interest to those starting out on their investment journey – it’s a good solid building block basis for a new portfolio.
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