Playing the American exceptionalism story

Sitting down to their Thanksgiving dinners this week many American investors may be asking themselves whether they can simultaneously have their pumpkin pie and eat it. Can they take advantage of the ‘tax-cut and tariff Trump Trade’ while also protecting themselves from a market with worrying echoes of the dot.com bubble of 25 years ago?

Closing out a second year of exceptional gains in the US stock market, it is very hard to persuade anyone to bet against a Trump-fuelled rally continuing well into next year and beyond. But to stick with the S&P 500 today requires you to close your eyes and pretend that shares are not valued as unsustainably as they were a generation ago.

Whatever you think about Neil Woodford, he does say a lot of sensible things about investment. And this week in his Woodford Views blog he drew attention to some sobering facts about the US stock market. He noted that it represents 60 per cent of the value of global shares despite the US economy accounting for less than half as much of global GDP (26 per cent).

He pointed out, too, that the US market trades at a multiple of expected earnings (22.5) that is extremely high compared to other stock markets around the world and, perhaps more importantly, to its own history too. On the basis of the ratio of US share prices to the book value of companies’ assets, the market is almost as highly valued as it was in 1999. Same story, using the cyclically adjusted price-earnings ratio, popularised by Yale’s Robert Shiller.

As Goldman Sachs and others have pointed out, this matters. The expected return from shares is inversely correlated to these valuation measures at the time an investment is made. When you buy at a high valuation, your expected returns are low - and vice versa. This is true always and everywhere over the medium to long term even if over shorter periods valuation is a poor predictor of where markets are heading.

Most investors don’t want to believe that the very agreeable bull market of the past two years is hitting the limits of sustainability. Wishful thinking is a powerful force in financial markets, and it is currently evident in the glass-half-full narrative surrounding the President-elect. Everyone sees the growth side of the tax cuts and tariffs coin, but no-one wants to look at the inflation and higher for longer interest rates when it’s flipped over.

So, the ‘US exceptionalism’ story is gaining traction as we head towards 2025. And it is not hard to find the numbers to back it up. US corporate earnings are forecast to grow in the mid-double digits next year. American companies are expected to grow faster than their peers in the rest of the world, with higher returns on capital. The US economy was growing faster than the rest of the developed world even before Trump promised to pour fuel on the fire. The economy is in good shape and risks of a recession are fading.

Compare that to Europe, which has stagnated in recent years and faces a wide range of cyclical and structural challenges. Potential tariffs (from day one, Trump promises) are a headwind for the all-important car manufacturing sector. Or China, where the government appears to have given up on its 5 per cent GDP target. Policy moves may stabilise the property market, but no-one expects a return to previous levels of growth.

A rational response to all of this is to conclude that some exposure to the US continues to make sense, but one that limits the risk of investing in a market that may have gone too far too fast. One that’s being held up by blue-sky thinking about artificial intelligence on the one hand and political posturing on the other. Fortunately, there are a couple of ways that investors can do this.

The first opportunity was highlighted this week when the Russell 2000 index that tracks US smaller companies broke above its previous high, set as long ago as 2021 as the US economy emerged from the Covid pandemic. Smaller companies have been underwater for three years now while their larger counterparts have surged ahead. $100 invested in the Russell 2000 index in November 2021 is worth about the same today. The same amount invested in the tech-stock-dominated S&P 500 index is worth $130.

That’s at odds with the fact that smaller, more domestically focused companies are likely to be among the biggest beneficiaries of an America First program. It suggests that there’s quite a lot of catching up to do. And with hundreds of smaller companies to choose from in the US stock market, active managers are spoiled for choice. So, the first ‘pumpkin pie and eat it’ way into the US market is via its unloved small caps.

A second way of reducing the risk of investing in the US today is to consciously invest in a portfolio that avoids the most highly valued US stocks - either through a value-focused US fund or a global fund with a valuation or dividend bias. Both are likely to avoid the Magnificent Seven, so while they are going to have a US exposure it will likely be lower risk than, for example, a US or global tracker fund, which is really just a disguised bet on continued tech dominance.

Fear of missing out makes it difficult to turn your back on winning investments. And in the case of the US that is probably a good thing. It would be eccentric not to have an exposure to the world’s most dynamic and innovative economy in your investment portfolio. But weighting it away from the most highly rated sectors and towards the areas that have lagged and are now catching up looks like a good use of the holiday weekend.

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