An extraordinary year for the American equity market EJINSIGHT

2021 has been an exceptional year in many ways, especially when it comes to the US stock market. A strong first and second quarter, which saw “all boats” lifted, was followed by a second half in which the market continued to advance, but carried only by a few names. While the S & P500 has seen a remarkable 18% rise since April 1, the picture changes fundamentally once the names FAAMG (Meta, Apple, Amazon, Microsoft, Alphabet) and Tesla are removed. The S&P ex-FAAMG + TSLA never strayed from levels it first hit at the start of the second quarter and is now back to its April level. Notably, the outperformance of US stocks over global stocks also evaporates once the six names mentioned above are excluded. Another way to look at this bifurcation of returns is the large gap between the S&P index-level performance over the past six months and the average performance of all of its constituents. While the S&P has gained 10% since June, the average performance of stocks in the S & P500 names has remained stable. Indeed, a portfolio that was underweight the FAAMG + TSLA aggregate in recent months has almost certainly underperformed the US benchmark as a result.

Although it has been particularly pronounced this year, the outperformance of the US tech giants is not a recent development. Over the past five years, the FAAMG + TSLA aggregate has delivered around 500% return, eclipsing the 45% return in the rest of the market. More interestingly, FAAMG + TSLA’s returns were also way above their earnings, which only increased by around 200% over the same time frame. This again contrasts with the ex FAAMG + TSLA market returns which moved perfectly in line with earnings, leaving valuations at the same levels as in 2017.

Since US valuations are often viewed as extreme, it is now clear that this is largely due to the high PE levels for FAAMG + TSLA. The rest of the S&P Index has returned to its pre-COVID valuations after following a typical pattern throughout the cycle: As the economy emerges from recession, stocks are re-valued in anticipation of future earnings improvements. , followed by a mid-cycle devaluation as the expected earnings increases materialize. As a result, once we rule out FAAMG + TSLA, US stocks are not more expensive, relative to global stocks, than they were before COVID. Valuations can still be challenged, however. First, if the market were to start pricing weaker earnings ahead, multiples in general would most likely fall. Second, high-tech tech valuations may come under pressure from gradually rising real yields. Neither scenario can be ruled out over the next few months. The former would likely materialize in an environment of weakening macroeconomic data, the latter if macroeconomic data were to strengthen.

Is the general valuation premium of US stocks relative to the rest of the world justified? We believe so, given that margins have consistently been above levels in most other developed markets over the past decade. Relative to Europe, which makes up much of the rest of the world, the US net margins have consistently been around 3.5 percentage points higher, with the gap widening further over the two last years. Even taking into account the more favorable composition of the sector in the United States, the European margins are considerably lower as this is a phenomenon that goes beyond the technology sector.

The higher margins in the US market are likely due to a variety of reasons, ranging from more innovative products to lower effective tax levels. Another essential reason is the concentration of the market. Europe has not only a significantly higher share of mid-sized companies – many of which are not listed on the stock exchange – but also large-cap sectors that are less integrated due to established national structures. The main examples are the financial sector or the food retail trade. Ultimately, while large-cap tech may face growing headwinds in the near term, we believe the United States should be able to maintain its lead over the rest of the world for years to come. Structural earnings growth and performance are expected to remain well above the rest of the world, justifying higher valuations.

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Karsten Junius

Chief Economist, Head of Economic Research at Banque J Safra Sarasin

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