by Matthew Poterba, CFA, Senior Analyst, Richard Bernstein Advisors
History shows that returns are greatest when capital is scarce. But investors need to also realize that risks escalate when there is a glut of capital.
Valuation alone may not be a reliable short-term timing indicator, but crowded and overvalued markets have a greater risk of disappointment. Today, investors are generally ignoring global stocks and have increasingly crowded into a handful of very expensive US stocks. Because valuation is a prime determinant of long-term returns, these ignored market segments stand to benefit as sentiment begins to normalize.
Investors are crowding US equities
Many portfolios reflect what has worked best in the last decade rather than what may work going forward. Chart 1 shows the average equity positioning of tactical and strategic asset allocation strategies at six selected large investment firms. Relative to the global equity market, these strategies are significantly overweight the US at the expense of International Developed and Emerging Market stocks.
RBAās Global Equity ETF Strategy appears positioned dramatically different than consensus. We are meaningfully underweight the US and see significant opportunities outside the US.
Most stocks around the world look cheap
During periods of heightened investor interest, such as the current focus on the 'Magnificent 7,' stocksā valuations can soar beyond sustainable levels. Conversely, less popular markets may be undervalued. Over longer time horizons these valuation extremes typically correct as market conditions stabilize and investor sentiment adjusts. Equity valuations tend to behave like a rubber band, heavily influenced by investor psychology and sentiment.
Although these reversions to fair value may not occur overnight, valuations do act as an anchor ā gradually pulling stock prices toward their intrinsic value. Therefore, this would suggest that US market segments with the richest valuations today are likely to underperform over time. Similarly, undervalued US and international market segments are poised to rise as depressed valuations revert higher toward more normal levels (Chart 2).
US Stocks: A Tale of Two Markets
While the US market appears expensive on the index level, aggregate market statistics hide what could be a historic range of valuations. The āMagnificent 7ā dominate standard indices and look very expensive, and their weights in the major indices skew index valuation upward. Yet the vast majority of US stocks are relatively cheap. This stark valuation bifurcation has gotten more pronounced throughout 2023 (Chart 3).
Looking past the expensive āMagnificent 7ā reveals many undervalued opportunities across the US and international markets. This divergence highlights potential risks of crowding into already expensive stocks and underscores the prospects of overlooked areas. As valuation differences normalize, capitalizing on these out-of-consensus opportunities may reward investors willing to deviate from the herd.
It's impossible to predict when the valuation rubber band will contract (or snap?). However, the glut of capital rushing to such a small universe of stocks strongly suggests the universe of investment opportunities is much broader than simply 7 stocks.
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INDEX DESCRIPTIONS: The following descriptions, while believed to be accurate, are in some cases abbreviated versions of more detailed or comprehensive definitions available from the sponsors or originators of the respective indices. Anyone interested in such further details is free to consult each such sponsorās or originatorās website. The past performance of an index is not a guarantee of future results. Each index reflects an unmanaged universe of securities without any deduction for advisory fees or other expenses that would reduce actual returns, as well as the reinvestment of all income and dividends. An actual investment in the securities included in the index would require an investor to incur transaction costs, which would lower the performance results. Indices are not actively managed and investors cannot invest directly in the indices. Magnificent 7: Bloomberg Magnificent 7 Index. The Bloomberg Magnificent 7 Total Return Index is an equal-dollar weighted equity benchmark consisting of a fixed basket of 7 widely-traded companies classified in the United States and representing the Communications, Consumer Discretionary and Technology sectors. US ex Mag 7: Bloomberg US Large Cap ex Magnificent 7. The Bloomberg US Large Cap ex Magnificent 7 Total Return Index is a float market-cap weighted benchmark designed to measure the most highly capitalized US companies, while excluding securities whose parent company is an index member of the Bloomberg Magnificent 7 Index. ACWIĀ®: MSCI All Country World Index. The MSCI ACWIĀ® Index is a free-float-adjusted, market-capitalization-weighted index designed to measure the equity-market performance of global developed and emerging markets. Europe: MSCI Europe Index: The MSCI Europe Index is a free-float-adjusted, market-capitalization-weighted index designed to measure the equity-market performance of Europe developed markets. US: MSCI USA Index: The MSCI USA Index is a free-float-adjusted, market-capitalization-weighted index designed to measure the equity-market performance of the United States. UK: MSCI United Kingdom (UK) Index: The MSCI United Kingdom Index is a free-float-adjusted, market-capitalization-weighted index designed to measure the equity-market performance of the United Kingdom. Japan: MSCI Japan Index: The MSCI Japan Index is a free-float-adjusted, market-capitalization-weighted index designed to measure the equity-market performance of Japan. EM: MSCI Emerging Markets Index: The MSCI Emerging Markets Index is a free-float-adjusted, market-capitalization-weighted index designed to measure the equity-market performance of global emerging markets. China: MSCI China Index: The MSCI China Index is a free-float-adjusted, market-capitalization-weighted index designed to measure the equity-market performance of China.
