Can the US economy continue to defy the sceptics?

A recent note from Goldman Sachs created a stir by suggesting that the US stock market would deliver a total return - capital growth and dividends - of just 3% a year over the next 10 years. That would certainly be disappointing compared to both recent returns (13% a year over the past decade) and the longer-term average (11% a year). In the nearly 100 years since 1930, investors have enjoyed a better outcome than this more than 90% of the time.

I don’t think anyone should be particularly surprised by this prediction, however. The US stock market is significantly more expensive than its peers around the world. And there is plenty of evidence that investing when the market is high tends to lead to relatively poor long-term returns. I think the main thing that prevents us from acting on this knowledge is wishful thinking.

Stock markets are driven in the long run by two things: earnings and valuations. Company profits bounce around a little, but generally, they rise over time. The more volatile part of the equation is the multiple of those earnings that investors are prepared to pay for a share of the action. The ups and downs of investor sentiment mean that the market swings from being under- to over-valued. More than 15 years after the market bottomed out in the wake of the financial crisis, we are probably now at the top end of the range.

These things are easier to see with hindsight than they are in real-time. At the top of the dot.com bubble in 1999 it was similarly obvious that markets were overcooked. But many investors were caught out, trying to squeeze one last bit of profit from the 18-year bull market. Similarly, in 1974 when blue-chip companies offered double-digit yields, it should not have been difficult to spot the buying opportunity. But it’s remarkable what losing three-quarters of your savings in a couple of years can do to your confidence.

Today, the S&P 500 is valued in the 97th percentile compared to history. That means that it has only been more expensive in three years out of a hundred. Will we look back on today’s market and either congratulate or kick ourselves, according to how we responded to what may then look blindingly obvious?

In addition to the truism that a high entry point leads to poor returns, Goldman Sachs makes a couple of other observations. It notes that high sales growth and profit margins are difficult to sustain over time. Over the past 40 years, only 3 per cent of companies have managed to grow sales at 20 per cent or more a year for a decade. And only one company in a hundred has delivered a profit margin of more than 50 per cent for that length of time.

These facts tend to be glossed over by over-optimistic investors in bull markets. The ‘one-decision’ stocks that fuelled the Nifty Fifty mania in the early 1970s, the internet stocks of the late 1990s and the assumed artificial intelligence (AI) winners today are all supported by a belief that high growth rates can be extrapolated indefinitely into the future. History suggests that’s not the case.

It’s not coincidental that both of the earlier periods of very high valuation were associated with high market concentration. Returns were driven by a small handful of stocks.

Concentration is a less effective indicator of investment outcomes than valuation, but again a high starting level is associated with poor index returns. And since 1930, the US market has almost never been this concentrated (just 1 per cent of the time).

So, the S&P 500 index is expensive and so concentrated that it carries with it a high degree of sector risk. If the tech, and especially the AI, story disappoints then so too could the US benchmark index. That’s the bad news. The more encouraging message is that this worrying picture is quite specific to this index, indeed to one narrow part of this index. If you look more broadly at the US market, and even more so at overseas equivalents, then both valuation and concentration are much less of a concern.

The good news is that the strength and vitality of the US economy, its innovation and its potential for sustained earnings growth can be captured both via a less focused US exposure and also through the US exposure of other markets. A third of the revenues of Europe’s biggest companies are currently captured in North America. Valuations in many markets around the world stand at a historically wide valuation discount to those in the US.

There are two obvious conclusions for an investor worried about the valuation and concentration of the US market. 

First, consider diversifying your holdings globally. Second, look carefully under the bonnet of the funds you invest in. A global tracker fund is likely to have significant exposure to not only the US but specifically to the highly valued, over-concentrated bit of the US market from which you should be looking to protect yourself.

Investing in US growth, and the global index funds that closely mirror its performance has been an easy decision in recent years. There has been no benefit in looking much beyond an S&P tracker fund, or even better a global tech stock equivalent. But if Goldman Sachs’ analysis is right then investing will be more challenging in the decade ahead.

There’s one other bit of good news in the bank’s analysis. And that is, its assumption that the tailwinds that have driven the market higher have further to run in the short term. It sees the S&P 500 rising to 6,300 over the next year. This optimistic view is predicated on expected earnings growth in 2025 of about 11% and only a modest decline in the market’s valuation multiple as the robust US economy continues to defy the sceptics. 

There is time to rebalance our portfolios. We should use it wisely.

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Please note that the views expressed in this article are my own.