Is the US share market uninvestable?

Is the US share market uninvestable?

Last week I was at a conference about alternative investments, and I cannot tell you how many people I spoke to who had decided the US share market is nuts. They were piling all kinds of arguments behind that view:

  • The S&P 500 has jumped 24% in just four months, but without the top tech stocks that return would be closer to 8%
  • Nvidia alone has gone up 95% over the same time, but it’s risen 420% since Chat GPT was announced in November 2022
  • Market concentration has never been greater with the MegaCap 8 stocks (Apple, Amazon, Alphabet, Meta, Microsoft, Netflix, Nvidia and Tesla) now accounting for 28% of the S&P 500
  • The MegaCap 8’s combined market cap would make it the second largest country stock exchange in the world
  • The S&P 500’s PE ratio is 28x, compared to a 30-year average of 17x
  • The Goldilocks US economy could crack any moment

Without digging any deeper, that’s a bunch of statistics that would be enough to have anyone wondering if the market’s gone a little mad.

So, let’s dig a little deeper.

Bears always sound smarter

First, before you go believing the people arguing everything’s turning to custard, just remember, the lizard part of your brain that’s hard wired to make sure you survived the thrills and spills of the savannah biases you to thinking what those people are saying is smarter and more trustworthy. It’s the survival instinct, designed to make us think twice and stop us from being reckless.

Then there’s what behavioural economists call second level thinking, where you take a breath and think for a moment, that can prevent you from just swallowing what people say without giving it some thought.

It’s the fundamentals

There have been lots of calls that the current AI boom is reminiscent of the dotcom bubble that popped in 2000, and it took the S&P 500 seven years to get back to that level.

But is it? The dotcom bubble was largely hypes and dreams, with almost no actual earnings to back it all up.

Compare that to Nvidia, which recently reported its fourth quarter results that smashed analysts’ forecasts:

  • Revenue up 265.3% to US$22.1 billion, 8.2% ahead of consensus
  • Data centre revenue up 408.8% to US$18.4 billion, 6.9% ahead of consensus
  • Gross margin up 1,064 bps to 76.7%, 128 bps ahead of consensus
  • Earnings per share up 486.4% to $5.16, 3.6% ahead of consensus

From the start of 2022 to 21 February this year, Nvidia’s earnings have grown 231%, but the stock price had risen only 130%, because the PE multiple, which is a measure of how much sentiment is driving the share price, actually detracted by 102%. In other words, there’s less hype in the share price over that time.

AI has certainly captured the market’s imagination, but it’s no fairytale, there’s real money behind it. Of course, we don’t know if the earnings and revenue growth are going to keep going, but check chart 1: spending by US companies on computers and electronic stuff had already got a big boost from Biden’s CHIPS Act and the Inflation Reduction Act, both passed in August 2022. But you can see the huge jump after Chat GPT was launched in November 2022 – US companies are clearly spending up in a race to incorporate AI into their businesses.

Chart 1: there’s real money going into IT spending in the US

Anyone who’s witnessed the magic of AI through Chat GPT or Google’s Gemini has to admit it’s a mind-bending experience, and those consumer-oriented models are the proverbial tip of the iceberg. There’s a website called Hugging Face, which calls itself “The AI community building the future” that has more than 520,000 AI models available.

AI is definitely here to stay. It’s definitely going to have far reaching impacts. And it’s only going to get bigger and better (and possibly scarier).

Market concentration ain’t all it’s cracked up to be

There’s been a lot of talk about the fact that the top 10 stocks in the S&P 500 have never represented such a high proportion of the overall index, usually followed by dark warnings about concentration risk.

Here’s a bit of context: the top 10 stocks in the US account for 34% of the S&P 500; in Australia, it’s 47% of the ASX 200; in the UK it’s 49%; Germany and France it’s 58% and in Italy it’s 66%.

In other words, it’s not a big deal. Yes, if the bigger companies fall hard it will impact the index by more, but clearly that’s not unique to the US.

There are two other important indicators for the broader US market. First, the industrials index, which represents old fashioned companies that manufacture stuff, has hit an all-time high, and the S&P 500 equal weighted index, which ignores market caps so all companies carry the same weight and influence (so it neutralises the MegaCap 8), is also close to an all-time high. They are both indicators telling us the rally is gradually becoming broad based.

How representative is the PE ratio?

Yardeni Research says the S&P 500’s PE ratio for the next 12 months was 20.4x on 15 February. For the MegaCap 8 it was 28.0x and for the other 492 stocks in the index it was 18.2x – see chart 2.

Chart 2: the S&P 500’s PE ratio with and without the MegaCap 8

First, I wrote an article for the AFR about this a few weeks ago, explaining how the US index has a much higher proportion of high growth tech companies than any other index in the world, so comparing the PE for the US to, say, Australia, where more than half our market is taken up by low growth banks and resources companies, is like comparing the proverbial apples and oranges.

For a bit more context, a company’s PE ratio is determined by a combination of how much the earnings are expected to grow and how positive or negative sentiment toward the company is. Forecasting earnings growth is hard enough, but forecasting sentiment is, well, impossible.

Suffice to say though, Yardeni reckons the 3-5 year earnings growth for the MegaCap 8 is forecast to be 38.9%. That’s really high, and if they can pull it off (admittedly a big if), maybe a 28x PE ain’t so bad after all.

The second part to this argument is that paying 18x for the rest of the US market might not be so bad either. It’s a smidge over the 20-year average PE of 17x, but, again, the US index has changed enormously over those 20 years. In 2003 financials was the biggest sector in the US at 20% and technology was 17%, but now financials is only 13% and tech is 30%. So, to suggest that the index should be trading on the same PE as it was when the composition was very different doesn’t make sense.

Looking into the almanac

There’s a group in the US called Carson Investment Research, and they trawl through data about the US share markets to spot trends and patterns, something I call almanac investing. I’ve highlighted two out of the many positive points they’ve raised about the S&P 500.

The santa claus rally
Zweig Breadth Thrust (ZBT)

You could understandably dismiss both of these observations as not much more than coincidences and say precedents like these are just made to be broken.

However, the reason I highlighted them is that I think they reflect a pattern of investor behaviour, which in large part is the all important swing factor of sentiment.

The US economy is still strong

The US economy defied a hugely overwhelming consensus that there was going to be a nasty recession last year. Whilst now consensus is that there will be a “soft-landing” (a soft way of saying they were wrong), there are still some bears holding out for a downturn.

Look, they may turn out to be right, if there’s one lesson we all should have learned by now it’s that forecasting the macro economy (things like inflation, unemployment, etc) is really difficult, but there are a few indicators of what’s happening in the real economy that I find persuasive.

First, real wages have grown steadily since COVID, and people having more money to spend is an unequivocal positive.

Aggregate weekly payrolls deflated by PCE inflation

Importantly, most of the growth in wages is going to the lowest paid workers, who are far more likely to spend it.

Graph: Average hourly earnings delated by PCE price index

Inflation in the US looks like it’s now well within the Fed’s target range of 2-3%, especially if you exclude housing (which they call shelter).

CPI Changes

Why would you do that? Because the Bureau of Labour Statistics, which calculates the CPI, uses a reading for shelter which every man and his dog knows is about 12 months behind the real market. The Fed knows it too, so why they persist remains a mystery.

The chart below shows the Zillow (the US equivalent of realestate.com) rental index advanced by 12 months. In other words, the Zillow index peaked in the middle of 2022 and has been declining ever since. Price increases on apartment rentals have fallen so much they’ve gone negative, meaning rents are dropping. Overall, real world evidence suggests housing costs are way below where the Fed is presuming they are, and they’re still going down.

Graph: rent measures year over year % change

And why is it important? Because shelter accounts for about 30% of the CPI number, and 40% of the so-called “Core CPI”, which excludes food and energy costs and which the Fed says it watches more closely.

In turn, the critical follow on from that is interest rates do not need to stay so high if inflation is back in the target zone. The prospect of the Fed eventually lowering interest rates is a big part of what’s got the share market excited.

Finally, another bit of real-world evidence that the economy is pretty strong is shown in the incredible rise of manufacturing construction spending, which has taken off in response to the Biden administration’s Inflation Reduction Act, which throws a bunch of different subsidies at anything that resembles an energy transition project.

Graph: Real manufacturing construction spending

The bottom line

It’s true the US share market has notched up some strong returns and has hit a new all-time high, but that doesn’t have to mean it’s on the verge of falling again. There’s plenty of anecdotal, technical and fundamental evidence to back the move.

Nor does it mean the index can’t go through a serious correction. On average, the US market experiences a 14% intra-year decline every year.

At the end of the day, trying to time a market by selling and buying back again is really, really difficult. Take comfort that the bears have been wrong since the market bottomed in October 2022, why should they necessarily start being right now?

Maybe the US share market isn’t as expensive as you think

Maybe the US share market isn’t as expensive as you think

The US share market has just hit a new all-time high and its returns have smashed the rest of the world for the past 15 years. But US shares also trade on valuation multiples that are much higher than the rest of the world, leaving investors who already own US companies wondering if they should lighten off, and those who don’t wondering if they should wait for prices to fall before buying in. But maybe the US market isn’t as outrageously expensive as most commentators would have us think.

America: home of the best companies, land of innovation

America is uniquely positioned, making it very difficult to bet against in the long run. Goldman Sachs points out that not only is it the biggest economy in the world, accounting for 26 per cent of global GDP, it is bestowed with an abundance of natural resources. It has the most arable land of any country and is now the world’s largest exporter of agricultural commodities, and, at 20 million barrels per day, it is also the world’s biggest oil and gas producer and exporter, with daylight to Saudi Arabia at number two with 12 million.

It also has the most favourable demographics of any developed country, the most productive labour force, and boasts the deepest capital markets, more than seven times the next biggest.

Since the late nineteenth century, the US has been at the forefront of technical innovation, boosted by some of the best universities in the world. In 2022, it was the global leader in R&D, spending US$879 billion, more than the next five countries combined.

And with exports accounting for only 12 per cent of GDP, the US economy is more resilient than most large economies because it’s less affected by cyclical downturns in its trading partners. By comparison, exports are 21 per cent of China’s GDP, 26 per cent of Australia’s and 51 per cent of Germany’s.

This is not to say the US doesn’t have its problems: it practices a brutal form of capitalism that results in a more limited social safety net, its health outcomes are an embarrassment, and its sclerotic, highly partisan political system is heavily influenced by wealthy lobby groups. Ironically, all of those problems are the result of prioritising making money.

World beating returns

It’s no coincidence that most of the best companies in the past 100 years came out of the US, culminating in today’s mega cap tech monsters.

If a smart investor had sunk $100,000 into the US’s S&P 500 index at the trough of the GFC in March 2009, and reinvested the dividends, it would have grown to be worth $946,000 by the end of 2023. The same investment in the ASX 200 would have been worth $524,000, even after including franking credits. That’s a difference of more than 80 per cent.

However, that incredible run has left the US share market looking expensive compared to the rest of the world. Using the most common valuation measure for shares, the price to earnings (PE) ratio, the S&P 500 trades at 19.5x 2024 forecast earnings, compared to Australia’s 16.4x, Europe’s 12.8x and the emerging markets’ 11.9x – see chart 1.

Chart showing bond yields trended down, resulting in a 40-year bull market, which went into reverse in mid-2020

Understandably, on that basis, almost every analyst and strategist recommends an underweight position in US shares.

However, a simple comparison of PE ratios fails to account for the huge differences in the structure of the US market compared to others. For example, the tech sector has a 29 per cent weighting in the S&P 500, and is on a forward PE ratio of 31x, which looks very pricey, but the index has had compounded annual returns of more than 21 per cent for the past 10 years. The two biggest companies, Apple and Microsoft, have both returned 26 per cent for those 10 years, and the third biggest, Nvidia, an eye popping 63 per cent per year. It’s also worth noting that the technology index doesn’t include other mega caps such as Google, Amazon, Netflix or Meta.

Chart showing the Australian government bond, GSBG33, has experienced higher 
volatility than what many would associate with a defensive investment

By contrast, the biggest sector in the ASX 200 is the financials, at 27 per cent of the index. Its 10-year return has been 8 per cent per year, and it’s on a forward PE of 15x. So that’s 60 per cent lower returns but only a 50 per cent lower PE. If the Australian index had the same sector weightings as the S&P 500, its PE ratio would almost double.

Chart showing the Australian government bond, GSBG33, has experienced higher 
volatility than what many would associate with a defensive investment

J.P. Morgan also argues that because free cash flow margins are 30 per cent higher than they were only 10 years ago, a higher PE is justified, and fund manager, GMO, points out that since 1997, US profits, as measured by the average return on sales, have increased by 40 per cent.

It’s very difficult to mount a case that US shares are cheap, but it helps to have context around why they’ve enjoyed an outstanding 10 years of returns. There’s no way of telling if those returns will continue to be anywhere near as high over the next 10 years, but it’s hard to argue against American exceptionalism when it comes to making a buck.

2024: What just happened and what lies ahead

2024: What just happened and what lies ahead

2023 – the scorecard

2023 started off with all kinds of dire forecasts, there had never been such an overwhelming consensus that the US economy would slump into recession and take share markets with it. But not only did the economy power through, so did share markets, and despite a choppy start to the year, they finished with a powerful rally that saw respectable returns across the board – see chart 1.

As well as a strong performance out of the US, Japan had a storming year on the back of solid earnings growth, finishing at the highest since its legendary boom of the 1980s, and Germany, where the economy continues to flirt with recession, is also trading at all-time highs, as is India.

Chart showing bond yields trended down, resulting in a 40-year bull market, which went into reverse in mid-2020

The story of last year was pretty much the mirror image of the previous year: 2022 saw markets fall because of negative sentiment, known as “PE compression”, whereas 2023 was largely about PE expansion, or positive sentiment. What that means is that theoretically share prices should go up (or down) by the same amount as earnings growth + dividends, and anything more or less than that is attributable to sentiment, that is, whether investors are feeling bullish or bearish, which is measured by changes in the price to earnings (PE) ratio that people are willing to pay. The grey bars in chart 2 show just how much of a contribution that positive change in sentiment added to returns in 2023.

Chart showing the Australian government bond, GSBG33, has experienced higher<br />
volatility than what many would associate with a defensive investment

It was all about inflation

The positive change in sentiment was all driven by changes in the outlook for inflation and interest rates, or more specifically, the market’s perception of whether central banks have finished increasing rates and, if so, when will they start cutting them?

Inflation rates across the world have indeed fallen considerably, but how much of that is attributable to central banks increasing interest rates is unclear. It’s pretty conspicuous that, despite the variability in when and how different central banks responded, the cycle we’ve just experienced has played out similarly across the developed world: inflation rates started rising sharply in 2020, peaked for most countries around the middle of 2022, and have been falling at a pretty similar pace since – see chart 3.

Chart showing the Australian government bond, GSBG33, has experienced higher<br />
volatility than what many would associate with a defensive investment

There’s a school of thought that disruptions to the supply chain were a significant contributor to inflationary pressures. The New York Federal Reserve Bank compiles an index that tracks pressure across global supply chains, see chart 4, and it traces a similar path to the inflation chart above. For a little context, the COVID-induced bottlenecks in the supply chain saw the index peak at almost 4.5 standard deviations above the average, which puts it so far out of the norm that the theoretical likelihood of it happening is close to zero. That kind of event is inevitably going to have serious consequences.

Chart showing the Australian government bond, GSBG33, has experienced higher<br />
volatility than what many would associate with a defensive investment

Likewise, raising interest rates aims to control inflation by reducing demand, but in the US, demand has remained very strong, indeed, GDP growth was 5.1% in the September quarter! So with demand going up, it’s hard to argue inflation coming down is because of higher interest rates.

Critically, in its last meeting for 2023, the US Federal Reserve acknowledged they think rates have peaked and the next move will be down. That lit a fire under financial markets, with both share and bond prices jumping, and kicking off furious speculation as to when the first cuts will come and how deep they’ll be.

Here in Australia, speculation is rife as to whether the Reserve Bank has also finished with rate rises, with some economists forecasting rate cuts before the end of 2024.

Lessons from 2023

As always, there are lessons to be learned (and perhaps relearned) from what happened in financial markets last year.

Macroeconomic forecasting is really hard (if not useless): at the end of 2022, there had never been such an overwhelming consensus among economic forecasters, and central bankers, that economies across the developed world were headed for recession. Forecasts for inflation were uniformly high, and for GDP growth, uniformly low. They weren’t even close.

There were dark mutterings from economists and central bankers reaching for the orthodox textbooks that unemployment rates were way too low for inflation to fall, and our new RBA Governor, Michelle Bullock, suggested Australia would need a jobless rate of 4.5% to relieve inflationary pressures, or a lazy 140,000 workers losing their job. Yet inflation rates have come down and unemployment rates remain at multi-decade lows.

The takeaway: the US Fed has hundreds of PhD economists and still can’t guess where inflation, unemployment or GDP growth will be less than a year out, but they continue to dominate headlines. You’re better off ignoring them, and certainly don’t let them influence your financial decisions.

It’s also worth bearing in mind, given markets have rallied on speculation of rate cuts, for that to happen implies not only that central banks believe inflation is under control, but that economic growth is softening to the extent it needs a boost from lower interest costs. There’s no guarantee on that.

Geopolitics is noise: there has been no shortage of geopolitical headwinds for financial markets to negotiate over the past couple of years. The Russian invasion of Ukraine was supposed to crush economic growth because of higher commodity prices, tension between the US and China had the media in a froth, and then another war in the middle east threatens to escalate. Yet markets have gone onwards and upwards.

The fact is, while wars are tragic and terrible and sabre rattling might keep us up at night, markets will only suffer enduring effects if corporate earnings take a hit.

Market concentration is not necessarily a bad thing: by the middle of last year, the US market had risen about 20%, but it had come entirely from the top 10 stocks. Bearish commentators were warning that investors in the US market were taking bigger and bigger risks because the weighting of the top 10 companies in the S&P 500 had never been so high, hitting 32%. By the end of the year, those 10 stocks had risen 62%, while the bottom 490 had gone up by a far more pedestrian 8%.

Australian investors should have no concerns about market concentration, given the top 10 companies in the ASX 200 account for more than 46% of the index.

It’s entirely possible the top 10 companies in an index could underperform or even fall, but if the rest of the rest of the companies in the index perform strongly, it will generate a good return. If a portfolio was comprised of nothing but the top 10 companies, obviously the risks are different, but some simple diversification can address those problems.

Bonds can be just as volatile as shares: traditional portfolio construction includes an allocation to bonds based on the theory that they reduce portfolio volatility and can act as a counter-correlated airbag to share markets.

While 2023 was nowhere near as bad for bonds as the record losses of 2022, they were still far more volatile over the year than shares, indeed, as chart 5 shows, the intra-year drawdown for US, German and UK 10-year bonds was around 40%, more than four times the drawdown of the S&P 500 and ASX 200 at their worst.

Chart showing the Australian government bond, GSBG33, has experienced higher<br />
volatility than what many would associate with a defensive investment

The outlook for 2024

While there are still a few bears growling about potential recessions, most forecasts are for equity markets to rise in 2024, and it’s even easier to find bond market bulls (though a lot of them are bond fund managers, so you have to be wary).


Australian company earnings dropped by more than 8% in 2023, having gone up by 16% the year before. One of our asset allocation consultants, farrelly’s, estimates long-term trend earnings growth for Australian companies at 3% per year, so given the recent fluctuations, it’s hardly surprising the current forecast is for about 1.2% earnings growth for 2024.

Of course, Australian shares typically pay a generous dividend by international standards, of about 4.4%, add 1.2% to that and you’d get a 6.6% return, which compares to a 30-year average annual return of 9.2%. We could reach that higher number if the PE ratio continues to expand, or if earnings are better then forecast. Of course, for those who benefit from franking credits, you can add an extra 1.4% to those numbers.

The ASX 200 finished 2023 on a forward PE ratio of 16.4x – see chart 6, which compares to a 20-year average of 14.6x. On that basis, it looks a little expensive, but it could simply be the market factoring in an earnings recovery.

Chart showing the Australian government bond, GSBG33, has experienced higher<br />
volatility than what many would associate with a defensive investment

United States

This is where things get really interesting. As noted above, in 2023 the US market was dominated by a handful of mega-cap tech companies, while the ‘bottom’ 490 stocks were pretty pedestrian by comparison.

The S&P 500 finished 2023 on a PE ratio of 19.5x, a hefty 17% premium to the 30-year average of 16.6x – see chart 7. However, if you break that down, the top 10 companies were on a PE of 27x, while the rest were on 17x. In other words, the ‘rest’ of the market is not expensive by historical standards.

Chart showing the Australian government bond, GSBG33, has experienced higher<br />
volatility than what many would associate with a defensive investment

J.P. Morgan argues the market is not especially expensive given companies reported free cash flow margins 30% higher than they were only 10 years ago, with a lot of that growth coming from the big tech companies. US funds management group, GMO, also points out that US corporate profitability, as measured by return on sales, has averaged 7% since 1997, compared to 5% before that – that’s a whopping 40% higher.

For 2024, the average forecast for the US market across 20 different international financial groups is a gain of 10.2% – for what that’s worth (which isn’t much). Of more relevance, corporate earnings are forecast to grow by 11.5%, plus the S&P typically pays a dividend yield of around 1.5%, which comes to 13%, roughly in line with the last 15 years average return of 13.8%, but comfortably above the 30-year average of 10.1%.

Something that plays on every asset allocator’s mind is chart 8 – which shows how extreme the US’s outperformance compared to the rest of the world has been since the GFC. Not surprisingly, most allocators look at that chart and immediately reduce the weighting to US shares. There are many explanations for the outperformance, not the least of which is that areas like Europe have been mired in an austerity mindset since 2009. There are, of course, two ways the gap could close: the US could fall heavily, or the rest of the world could make huge gains – or the trend could keep going. Unfortunately, there is no way of knowing.

Chart showing the Australian government bond, GSBG33, has experienced higher<br />
volatility than what many would associate with a defensive investment

Notably, in terms of valuations, the rest of the world (ex the US), is trading on a PE ratio of 12.9x, compared to a 20-year average of 13.1x, so fractionally on the cheap side. However, that’s a 34% discount to the US, which is the highest in at least 20 years.

Here are a few interesting observations, based on historical return for the US:

  • In late November last year, the S&P 500 made a new high since January 2022, i.e. it had been more than a year, and on the 14 previous occasions that’s happened, the market rose by an average of 14% over the following year and was positive 93% of those times
  • Since 1928, when the S&P has gone up by more than 20% in a calendar year, the average gain the following year was 11.4%, and it was positive 65% of the time
  • Since 1933, the fourth year of the presidential cycle has seen an average return of 6.7%, and is positive around 70% of the time
  • Deposits into money market funds last year were 13x more than what went into equities, taking total deposits to a record US$6 trillion, which on their own are expected to generate US$300 billion in interest income

Emerging markets

With a forward PE ratio of only 11.9x, the emerging markets look cheap compared to developed markets, however, that number is bang on the 25-year average and they’ve looked cheap for years and have underperformed the developed markets badly since the end of the GFC – see chart 9.

Chart showing the Australian government bond, GSBG33, has experienced higher<br />
volatility than what many would associate with a defensive investment

At a 26% weighting in the EM index, China is the 600-pound gorilla in the asset class, and it had a miserable 2023, falling almost 13%. Much of that is because the government refused to inject COVID stimulus at the household level, unlike western governments, forcing families to draw on their savings to get through extended lockdowns, and leaving consumers reluctant to spend once restrictions were lifted.

On top of that, the property sector, which was estimated to have contributed as much as 20% to GDP growth, is in disarray. The government has actively supported the rapid development of the electric vehicle industry, and now China makes more EVs than the rest of the world combined. It is possible that will be a strong new source of growth for the economy over the coming years.

By contrast, India, which is 17% of the index, is shooting the lights out, returning 20.3% in 2023 and hitting a new all-time high, and 15.8% per annum for the last three years. A combination of favourable demographics and a booming tech sector has proven to be a terrific tailwind.

Emerging markets returns tend to go in long cycles and appear to be linked to long-term trends in the US$, and trying to guess where currencies are going is even harder than share markets. The bottom line is that when an asset class is as cheap as EM is at the moment, it makes sense to have at least some weighting.

Real assets

Traditionally one of the more interest rate sensitive sectors, real assets, like property and infrastructure, have been beaten up badly over the course of the current interest rate cycle, but they turned sharply at the first hint that rates have peaked. In late October last year, the VanEck Global REIT ETF (REIT) was down by almost 40% from its peak, but then rallied more than 40% by the end of the year.

Chart 10 shows the relative earnings multiple that global REITs is trading on compared to equities puts them very much on the cheap side relative to the long-term average. The level of EBITDA hasn’t changed significantly, but the multiple it’s trading on has been derated to levels similar to the GFC and the COVID sell off, which is all sentiment-driven.

Chart showing the Australian government bond, GSBG33, has experienced higher<br />
volatility than what many would associate with a defensive investment
Small cap companies

Small cap companies is another asset class that has been brutalised over the past couple of years, both in Australia and internationally, to the point where they are now trading at multi-decade lows relative to large caps – see chart 11.

Chart showing the Australian government bond, GSBG33, has experienced higher<br />
volatility than what many would associate with a defensive investment

Notably, the US small cap index, the Russell 2000, jumped 26% from its lows at the end of October. Once again, since the index’s inception in 1979, there have been 21 previous occasions where it has rallied more than 20% in 50 days, and the average increase one year later was 16.5%, and it has never been lower. That compares to the average 12 month return of 10.5%.

Again, given how relatively cheap small caps are, it makes sense to have at least some allocation.

Fixed income

One of most popular sayings in financial markets recently has been, “Bonds are back!” The argument is that investors are now receiving a yield to invest in government bonds, unlike a few years ago where yields were approaching zero and, in many cases, actually went negative!

The prospects for bonds depends entirely on what happens with interest rates and inflation. Being paid to hold them is a start, but bond prices can be quite volatile – as discussed above.

Private credit continues to grow its share of the commercial lending market in the US, Europe and Australia. We remain strong supporters of well managed private credit backed by strong levels of security and low LVRs, with returns comfortably above those offered by bonds and, typically, zero volatility in the underlying unit price.


Financial markets have a knack for surprising, and 2023 was a great example of that. The headwinds that caused mayhem a couple of years ago have dissipated, but whether they become the tailwinds the market is hoping for is yet to be seen.

After what turned out to be a year of good returns in 2023, there are sound fundamental arguments to support a positive view on share markets for 2024, and there are certainly asset classes and sub-sectors that look relatively cheap.

The big spending that could keep the US out of recession

The big spending that could keep the US out of recession

In September last year, Bloomberg reported that 100 per cent of surveyed economists expected the US economy to recess in early 2023, and strategists were warning of calamitous markets ahead. Of course, that didn’t happen, and whilst GDP growth of a smidge above 2 per cent per year isn’t going to knock anybody’s socks off, it’s far from going backwards, and the US share market rose 20 per cent to the middle of 2023.

Economists tend to follow an approach where they try to fit today’s circumstances into a historical analogy, saying “I think what’s happening with inflation and interest rate rates today is not dissimilar to the 1970s/1980s/whatever period”, and base their forecasts on what transpired back then.

The thing is, none of those past rising interest rate episodes were preceded by the federal government shoving 25 per cent of GDP into household bank accounts, which was what happened with the COVID stimulus cheques. That massive fiscal injection had two effects: first, it set the economy on fire, sending unemployment levels to 50-year lows; and second, households had never enjoyed such a large savings buffer to cushion against rising prices. As a result, the US economy’s resilience took orthodox economists and strategists by surprise.

Once again, we are seeing a growing consensus that the US economy is going to recess next year, which brings with it the usual talk of America sneezing and the rest of the world wrestling with swine flu.

Concerns that the Federal Reserve is going to increase interest rates again, that rising bond yields will make shares increasingly less attractive, that the now long-standing inverted yield curve will somehow work its voodoo, that consumer confidence is falling, and households are running out of those excess savings, combine to paint a grim picture. Throw on top of all that a dysfunctional US congress and an approaching election plus the ongoing problems China is experiencing and it’s clear why the bears are once again on the prowl.

However, if you look hard enough, just like last year, there are some signs pointing in the other direction; signs that tend not to feature in most forecasts. And, again just like last year, they revolve around some significant fiscal injections and consumers that might be in a better spot than economists give them credit for.

The first of those fiscal injections is the interest the US government is paying on the more than USD33 trillion of bonds that are on issue, which has risen over the past three years from USD500 billion per year to more than USD900 billion. That may not be going into the pockets of the people who would spend it all, but it’s still going into the economy.

The second is the three signature pieces of legislation that have been dubbed ‘Bidenomics’, the CHIPS Act, the Infrastructure Act and the Inflation Reduction Act (IRA), which between them earmark more than USD2.25 trillion of government spending.

Between them, that amounts to more than 12 per cent of the US economy being injected through government spending programs, which are on top of the usual budget items. What’s more, the IRA, which basically invites any company with a decarbonisation project to apply for tax deductions, rebates or subsidies, is open ended, and Goldman Sachs estimates the amount being spent has increased from the original projection of USD780 billion to more like USD1.2 trillion.

When you add them up, it’s a ton of money being thrown into the economy, and those three government policies have catalysed a tsunami of corporate spending, with data from the US Treasury showing real manufacturing construction spending doubling to USD1.9 trillion over the year since they were passed – see the chart below – and non-residential construction spending in general is up 15% since the infrastructure bill. Overall, private sector spending has gone up three times more than public spending. In other words, the government’s policies are crowding in private sector spending.

Table showing the 2022 share market returns in local currencies

Regrettably, Australia is in the opposite position, with the federal government boasting of a surplus, which is sucking money out of the economy at a time when households spending is coming under a lot of pressure.

As for US consumers, while it’s true they’ve almost run out of excess savings from COVID, there’s still a base level of savings, plus household bank deposits are more than four-fold higher than pre-COVID at USD4 trillion. Then there’s the 50 per cent rise in money market fund balances to around USD6 trillion and a similar rise in home equity to almost USD32 trillion.

In other words, American consumers have a lot left in the tank to maintain that legendary appetite for spending.

It’s still entirely possible the US economy will hit a recession-sized bump in the road, but it’s far from a certainty. Smart investors will know better than to put their faith in economists and strategists who get things wrong as much as they get them right.

AI: boom, bubble or both?

AI: boom, bubble or both?

Over the first half of this year the US’s tech heavy NASDAQ index had one of its best ever starts to a year, rising 32 per cent and even the much broader S&P 500 rose a barnstorming 17 per cent.

Investors could understandably be left wondering how the share market could be so positive when the vast majority of economists were still forecasting a US recession. While there’s always a bunch of reasons for why markets move the way they do, a huge component was the excitement generated by Artificial Intelligence, usually known by its shorthand of “AI”. In fact, SocGen calculated that if you strip out the AI-related stocks, the S&P 500 was only up by about 2 per cent over those six months – see chart 1.

Table showing the 2022 share market returns in local currencies

As often happens with new technology there’s no shortage of controversy around AI, but no lesser than legendary Silicon Valley investor Marc Andreessen wrote, “AI is quite possibly the most important – and best – thing our civilization has ever created, certainly on par with electricity and microchips, and probably beyond those.”

Not surprisingly, analysts are falling over themselves trying to work out the implications of AI on company productivity and earnings, but at such an early stage anything they say is no better than an educated guess. It’s little wonder then that comparisons can be drawn to the dotcom boom of the late 1990s, when the whole world got swept up in the heady possibilities of the internet, and we know how that ended.

The AI boom really took off in late May after AI’s pin up child, Nvidia, not only reported first quarter earnings 20 per cent above analysts’ forecasts, but also increased its second quarter revenue forecast by a mind-popping 50 per cent – all due to AI demand for its computer chips. The shares jumped 26 per cent that day and rose a staggering 190 per cent in the first half of 2023.

So here’s the ‘but’: Nvidia shares are trading around 40x revenue. That’s not earnings, it’s sales, before costs – see chart 2. There was a handful of companies that traded on similarly high price to sales ratios in the dotcom boom and they all came back to earth – see chart 3.

Bar graph showing the main negative influence of share prices was sentiment based on source of return 2022 AUD
Bar graph showing the main negative influence of share prices was sentiment based on source of return 2022 AUD

The rise in the US indices has been driven almost entirely by sentiment, the technical name for which is ‘PE expansion’. Theoretically, share prices should go up in line with the net earnings of companies, but sometimes markets get carried away over the short-term, especially when a new paradigm arrives.

Analysts currently forecast earnings will rise by 1 per cent in 2023, so the 17 per cent rise in the S&P 500 so far reflects the optimism being priced into AI – see chart 4. Share markets are always forward looking, but while the forecast for 2024 is for a respectable 12 per cent earnings growth, the S&P is already trading on a PE of 19x, a 27 per cent premium to its 20-year average of 15x.

Line graph showing the probability of recession over the coming 12 months in the Fed's Survey of Professional Forecasters

There are some other signs of a frothy market:

  • The forward PE ratio for the MSCI World Tech sector relative to the rest of the market is more than two standard deviations above its 20-year average, i.e. it’s really high – see chart 5.
Line graph showing the Morgan Stanley Leading Earnings Indicator against the Actual S&P 500 LTM EPS Growth Y/Y
  • Very low bond yields and inflation pre-COVID supported higher PE ratios, especially for the growth-oriented tech companies. But now the gap between the US real bond yield and the S&P 500’s forward PE ratio has opened right up – see chart 6.
Line graph showing the US Bureau of Labour Statistics unemployment levels
  • The S&P 500 is more than 8 per cent higher than what strategists, on average, guessed it would be by the end of year, which is the second largest overshoot in 24 years.
  • Two of the best performing groups in the US year to date are non-profitable tech (+32 per cent) and the infamous ‘meme stocks’ from 2021 (+63 per cent).
  • The weekly J.P. Morgan fund manager survey reported only 17 per cent of managers were planning to increase their equity exposure over coming weeks, down from 50 per cent at the end of May.
Line graph shows 10-year treasure yields minus 2-year yields (1980 - Present)
  • The weighting of the top 10 stocks in the S&P 500 at the end of June was the highest in more than 27 years at 32 per cent, but their contribution to earnings growth was the equal lowest in over 20 years at 22 per cent- see chart 8.
Bar chart showing US inflation stats throughout 2022

You only need to play around with Chat GPT to know that AI is very special and will be a game changer, and it is progressing astonishingly quickly. At the end of day, even if this AI-inspired rally really is a bubble, we know bubbles can last a lot longer and go a lot higher than anybody expects. Smart investors will know it’s worth having some exposure, but maybe just don’t bet the farm on it, yet.