An extraordinary year for the US equity market

December 24, 2021 10:08
Photo: Reuters

The year 2021 has been exceptional in many ways, not least with regard to the American equity market. A strong first and second quarter, which saw “all boats” being lifted, was followed by a second half during which the market continued to grind higher, but carried only by a few names. While the S&P500 delivered a remarkable 18% rise since 1 April, the picture changes fundamentally once the FAAMG names (Meta, Apple, Amazon, Microsoft, Alphabet) and Tesla are removed. The S&P ex-FAAMG + TSLA has never moved far from the levels it first touched at the beginning of Q2 and is now back to where it was in April. Notably, the outperformance of US equities vs global equities also evaporates once the six names mentioned above are excluded. Another way to look at this bifurcation in returns is the large gap between the S&P’s 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 stock performance of S&P500 names has been flat. In effect, a portfolio that was underweight in the FAAMG + TSLA aggregate over 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 behemoths is no recent development. Looking at the past five years, the FAAMG + TSLA aggregate has delivered a return of around 500%, dwarfing the 45% return of the rest of the market. More interestingly, FAAMG + TSLA returns have also performed well ahead of their earnings, which have only risen by around 200% over the same time period. This contrasts once again with the market returns ex FAAMG + TSLA which has moved perfectly in line with earnings, leaving valuations at the same levels as in 2017.

Given that US valuations are often considered extreme, it is now clear that this is largely a result of elevated PE levels for FAAMG + TSLA. The remainder of the S&P has returned to its pre-COVID valuations after following a typical pattern through the cycle: as the economy moves out of recession, equities re-rate in anticipation of future earnings upgrades, followed by a mid-cycle de-rating as expected earnings upgrades materialise. As a result, once we exclude FAAMG + TSLA, US equities are also no more expensive, relative to global equities, than they were prior to COVID. Valuations, however, may still be challenged. Firstly, if the market were to start pricing for weaker earnings ahead, multiples in general would most likely fall. Secondly, high-flying tech valuations may come under pressure from gradually rising real yields. Neither of the two scenarios can be excluded over the coming months. The former would likely materialise in an environment of weakening macro data, the latter if macro data were to strengthen.

Is the general valuation premium of US equities over the rest of the world justified? We think yes, given that margins have consistently been above the levels in most other developed markets over the past decade. Compared to Europe, which accounts for a large chunk of the rest of the world, US net income margins have consistently been around 3.5 percentage-points higher, with the gap widening even further over the past two years. Even accounting for the more favourable sector composition in the US, European margins are substantially lower as this is a phenomenon which goes beyond the tech sector.

There are likely various reasons for the US market’s superior margins, ranging from more innovative products to lower effective tax levels. Another key reason is market concentration. Not only does Europe have a significantly higher share of midsized companies - with many of them not listed - but also less-integrated large-cap sectors due to established national structures. Prime examples are the financial sector or food retail. Bottom-line, while large cap tech may face rising headwinds over the short term, we believe the US should be able to sustain its edge over the rest of the world for years to come. Structural earnings growth and performance should remain well above the rest of the world, justifying superior valuations.

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Chief Economist, Head Economic Research at Bank J Safra Sarasin