Are you chasing returns in the US markets?

Investing in the US stock market has been a home run for the past ten years, but never far away is the old adage that ‘past performance is no guide to future performance.’  Here we outline why Europe could come in from the cold.

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results
US markets

The last ten years have seen US equities greatly outperform European equities, to the extent that many investors are asking themselves whether they should bother with Europe at all. In GBP terms the S&P 500, the index of the largest 500 companies in the US, gained 225% in the decade to the end of July 2017, while the MSCI Europe Index lagged significantly behind with a gain of 74%. 

The majority of the US outperformance was generated after the 2008-2009 financial crisis, a time in which European equities were facing sovereign debt problems in the eurozone periphery while the spectre of deflation loomed until European Central Bank (ECB) President Mario Draghi began his programme of quantitative easing (QE)

Chart 1: US outperformance

Whilst it is indisputable that US equities have enjoyed superb returns, investors with longer memories will recall that this was not always the case. As recently as the mid-2000s, after a prolonged period of underperformance following the dotcom boom, market commentators had genuine fears that corporate America had lost its competitive edge. There was also gloomy talk in the markets that US equity valuations would be permanently depressed due to the retirement of the baby boomers generation.

In the chart below we show the relative performance of the S&P 500 vs MSCI Europe over rolling three-year periods. Recent outperformance has been very strong, but over the past 25 years that has not always been the case. In the mid 2000’s European equities performed very well, with peak three year outperformance of 70% in March 2006. European equities were the asset class that everyone wanted to own.

Chart 2: relative performance of US equities

What drives market outperformance? 

In finance there are many measures of valuation, of which the price to earnings ratio (P/E ratio) and the price to book ratio (P/B ratio) are the most commonly used. P/E ratios can be very volatile as company earnings can fluctuate greatly depending on which part of the business cycle they are in. For example, mining companies can make very large profits when commodity prices rise, and similarly slump to large losses when prices fall back.

Using the P/B ratio offers a much more stable measure as it looks at accounting ‘book value,’ which is the company assets minus its liabilities. You can see this in the annual report.     

In the third chart below we compare the S&P 500’s relative P/B ratio valuation to that of MSCI Europe. At present the US trades on a P/B ratio of 3.1 times, with MSCI Europe on 1.8 times, this is a relative ratio of 1.72 times or a 72% valuation premium.

Using data going back to December 1998 we can see that the US has always traded at a premium to Europe, but right now it is approaching the most expensive it has been. Coincidentally, ten years ago (in July 2007), at a relative ratio of 1.27 times, it was quite close to the trough valuation.

The relative P/B ratio suggests that market sentiment has been a big driver of US equity market outperformance.

Graph 3: relative price to book valuation

Is the rise in US valuations all due to technology?

Technology now accounts for around 23% of the S&P 500, compared with 5.5% for Europe, and businesses such as Amazon, Facebook and Apple have made very large gains in recent years.

To test the theory we took two exchange traded funds (ETFs) which track these respective indices and looked at the sector valuations. The numbers are quite stark – every single US sector, aside from healthcare, is significantly more expensive than the European equivalent. 

Chart 4: sector P/B ratios

Sectors S&P 500 MSCI Europe Relative Ratio
Consumer Staples 5.41 3.98 1.36
Health Care 3.95 3.83 1.03
Information Technology 5.16 3.68 1.4
Industrials 4.59 3.29 1.4
Consumer Discretionary 5.15 2.32 2.22
Materials 3.82 1.98 1.93
Telecommunication Services 2.71 1.89 1.43
Utilities 2.03 1.62 1.25
Energy 1.89 1.21 1.56
Real Estate 3.34 1.13 2.96
Financials 1.41 1.12 1.26

Source: Bloomberg, August 2017

Should you sell your US holdings?

With Donald Trump’s presidency not exactly off to the smoothest of starts and European economic data continuing to surprise on the upside, it would not be completely shocking if US equities began to give back some of their more recent relative outperformance. 

However, when building a portfolio, it pays to have a global diversification, the skill is in how you weight your holdings. IG Smart Portfolios are designed to make these decisions easier for you. 

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