While US markets are undeniably in nose-bleed territory, the gap between the most highly rated and least highly rated stocks is at record levels. That means undervalued parts of the market could provide stellar returns in the coming years.

The performance of US equity market in recent years has been outstanding. The top 10 stocks in the MSCI World Index all hail from the US. The top 8 are all tech, or tech related companies (such as Alphabet or Meta). The US now accounts for 70% of the MSCI World. The next largest country is Japan, with a heady 6.2% weight. The UK comes in third at 4%. Back in 1990, the US weight in the index was half what it is today, and it’s never been higher.

Evidence of irrational exuberance in the financial markets is fairly easy to see today. More than 15 million Americans downloaded trading apps during the pandemic, and surveys show many of them are young, first-time buyers. US investors poured more than $1 trillion into equities worldwide in 2021; three times the previous record and more than the prior 20 years combined. Moreover, net margin debt (borrowing to buy stocks) is at an all-time high since records began 30 year ago. So there are plenty of narratives to choose from for those who prefer stories to numbers.

For those who prefer numbers, the US market is as expensive as it has ever been on a variety of valuation metrics. Among the most important is cyclically-adjusted PE (CAPE). The US trades on a CAPE in excess or 40x. There is no doubt this is nose-bleed territory: data from the last 120 years shows that investors have never gone on to make money over the subsequent decade when asked to pay such a lofty valuation. Exceptionally high valuations can only point to exceptionally low returns over the longer-term. These really are extraordinary times.

Graph - US Equity Cycle-Adjusted PE & Subsequent 10-Year Return

If this all sounds rather doom and gloom, there is a silver lining, and that comes in the form of valuation dispersions. This is the gap in fundamental valuation between the most highly rated shares and least highly rated, and it remains at extreme levels:

Graph - MSCI World, Value % Premium to Growth on P/E. P/BV & P/Div

On a global basis, the gap is more extreme than at the dotcom peak in 2000. And equity returns after the dotcom boom turned to bust showed the importance of having value exposure: three years after the bubble burst MSCI World was down 45%, but Value was up 25%.

Moreover, it is critical to highlight that any market valuation is a simple average of the valuations of the individual stocks within it. Even in the US we can find some genuinely attractive stocks for global portfolios, including those new purchases written about in this report, but given the aggregate market valuation they tend to be few and far between.

Ultimately, valuation dispersions mean that returns from the most undervalued parts of the market can be stellar over the coming years, even if overall market returns prove to be paltry. If the valuation gaps that we see today are to return to something more like normal in the context of long-term history, this value recovery has a long way to go.

Originally published by Schroders