What sets the US apart from other equity markets?

Dan Kemp

Dan Kemp

The 4th of July marks American Independence Day, when the second continental congress declared its independence from the British empire.

Now, 243 years later, it appears that America has once again achieved independence.

But this time it is America’s equity market that has broken free of the shackles of normal valuations and achieved a valuation level that sets it apart from other equity markets.

There are many credible reasons why the US should be treated differently from other equity markets.

For example, it is unusually liquid, diverse and is home to many of the world’s most vibrant and dominant companies.

In addition, profit margins are supported by a relatively strong local economy.

However, when investing it is important to remember that the majority of returns are delivered in the future and over the long term.

Our assessments of return must, therefore, also focus on the long-term future and take account of the fact that the future is uncertain and often surprising.

Nowhere is this lesson more obvious than in the defeat of the British empire in the revolutionary war.

As the future is uncertain, so are the returns that are generated in the future and consequently, it is necessary to be conservative when estimating the price one should pay for such returns.

This is especially important when the current outlook appears unusually rosy as there is typically more room for disappointment and less scope for a positive surprise.

However, our natural inclination to project our recent experience into the future, coupled with the peer pressure that arises from ‘missing out’ on short-term returns, can make it extremely difficult for an investor to be suitably cautious.

In view of this, it is worth reminding ourselves of some facts about the US equity market.

Using the cyclically adjusted price-to-earnings ratio data from Robert Shiller that goes back to 1871, we can see that US equities are currently priced in the highest 5 per cent of their historical valuation range.

The earnings that support these ratios are also unusually high, with US profit margins a whisker below their highest point in 23 years.

Consequently, investors buying US equities are paying usually high prices for unusually high earnings.

As both these measures tend to be cyclical, it seems unlikely that US equities will retain their independence from normal valuations for long.

But before we condemn US equities completely, it is worth remembering another lesson from the American revolution - that a war is primarily a series of battles rather than a single conflict.

Looking at a situation in a more granular way typically results in more valuable information.

It is for this reason that we tend to divide the US equity market into sectors when undertaking fundamental research.