The US market is up 14% from its mid-October lows. While this still places the US 15% below its all-time high in December 2021, the US market has performed very well based on longer time frames.
The recent solid bounce in the US market at a time of falling year-on-year (YoY) earnings has seen the price to earnings (PE) ratio move up again, raising fears that the US market is overvalued.
Commentary around US overvaluation is not particularly new. Indeed, several high-profile bears have been warning about US market overvaluation for much of the past 10 years. Over this 10-year period, the US market has delivered +12% per annum returns (US$ terms).
In our view, the case that the US market is overvalued is arguable to say the least. In particular, we feel the bear argument on valuation glosses over the quality and market dominance of the companies that dominate the US equity market.
Valuation: A Mix of Art, Science and Forecasting
Our approach is to look at valuation in a number of ways. We discuss our thinking in more detail below.
US Market Absolute Valuation (Price-to-Earnings)
A common approach to market valuation is to assess valuation (PE) versus a market’s own valuation history. While this is a worthwhile exercise, it is a more complex exercise than it may appear.
We need to consider what is the most appropriate valuation yardstick. Is it a more recent history, say 5-10 years, or a longer-term history, say the past 20-30 years, or even longer, if available?
In this respect, we are not convinced that a longer data set will yield a more accurate valuation picture in respect of future market prospects. This we feel is particularly the case with the US market given the huge compositional shift over the past few decades.
In this respect, the observation that the US market looks expensive versus its long-term (e.g., 30-year) PE average is interesting, but it is not a knock-out blow in favor of the overvaluation case, in our view. The US stock market looks more reasonably priced based on shorter-term time frames (e.g., 10 years). From this perspective, the debate would seem to hinge on whether we are merely observing a period of extended overvaluation, or a rational valuation uplift over the past decade based on the fundamental shift in the composition of the US stock-market toward dominant high-growth franchises.
Beyond changing market composition, shifts in the macro regime are also important. In short, are we leaving a regime of low inflation and low interest rates and entering a new “higher-for-longer” regime?
We believe that a low-to-moderate inflation and interest rate regime is still likely to prevail over the medium to long term, though not quite as low as investors have enjoyed over much of the past 10-15 years. This should continue to be supportive of “above average” valuations when assessed against long-term historic benchmarks.
Valuation Relative to Bonds
From the perspective of relative value versus interest rates, we have observed a fair amount of commentary lately that US stocks are now expensive versus bonds. This seems to be based on the past 10-15 years of evidence: a period of very low bond yields.
In contrast to the results of our analysis of absolute PE ratios, extending the “relative-to-bonds” analysis longer term suggests US stocks are close to fair value on this yardstick.
In short, while the US PE is on the high side versus the long-term average, US bond yields (even post the recent rise) are still relatively low. Therefore, relatively low rates, if maintained, continue to be supportive of above average equity valuations.
One misconception we would call out is that the earnings yield to bond yield spread represents an accurate estimate of the equity risk premium. Going back to first principles, the earnings yield is a real variable while nominal bond yields are, by definition, a nominal variable. This leads to the conclusion that a more accurate representation of the equity risk premium (ERP) is given by the earnings yield (just over 5%) relative to real bond yield (just over 1%, based on inflation expectations).
On this basis, the argument that there is very little equity risk premium is not accurate. The current ERP of around 4% looks quite reasonable.
Relative to the Rest of World
The US stock market has traditionally been a premium market and we would be surprised if anyone would argue with some degree of premium given the quality of companies in the S&P 500.
However, just how much of a premium is justified? The current premium (at 40%) is close to all-time highs. While the view that the US market is expensive versus regional peers has been a losing trade for many years, now the premium may be becoming stretched. We might be able to make a case for the rest of the world from a relative value perspective.
This may not mean the US market is overvalued in an absolute sense, but there may be better or equivalent value in the rest of world, even if company quality is inferior. We do not have strong conviction on whether the rest of the developed world offers better value over the medium to long term. We do see valuation appeal in emerging markets presently, but are more neutral on the rest of the world versus the US.
US Valuation Relative to its Growth Prospects
One point often glossed over is that the dominant return driver of US equity performance over the past 10 years has not been PE rating (although re-rating has made a sizeable contribution) but earnings growth. It is superior earnings growth that has driven the largest share of US performance in absolute and relative terms.
A view on whether the US PE re-rates, de-rates, or stays constant is important, but long-term earnings performance will likely hold the key to long-term performance. We expect US earnings performance will be less strong (for example, the past 10 years includes a generous corporate tax cut) but we still expect US earnings growth to outstrip the rest of the world based on the quality and positioning of US corporations.
From this perspective, a significant premium to the rest of the world is still warranted, although it remains possible that the rest of the world is finally fair or even cheap versus the US.
In absolute terms, we think the US market can hold its current multiple on the basis that it delivers solid EPS growth over the medium to longer term.
| Company Name | Market Cap (US$b) |
Forecast Multiple 12mth fwd PE |
EPS CAGR % (FY1-FY3) |
| Apple Inc | 2623 | 26.0 | 10% |
| Microsoft Corp | 2271 | 28.2 | 14% |
| Alphabet Inc | 1332 | 18.3 | 18% |
| Amazon.com Inc | 1067 | 52.9 | 52% |
| Berkshire Hathaway Inc | 704 | 19.3 | 11% |
| NVIDIA Corp | 681 | 54.7 | 33% |
| Meta Platforms Inc | 598 | 18.1 | 20% |
| Tesla Inc | 511 | 39.9 | 33% |
| Visa Inc | 462 | 24.0 | 14% |
| UnitedHealth Group Inc | 454 | 18.5 | 13% |
| Exxon Mobil Corp | 429 | 10.6 | -5% |
| Johnson & Johnson | 421 | 15.0 | 4% |
| Walmart Inc | 406 | 23.7 | 10% |
| JPMorgan Chase & Co | 393 | 9.4 | 3% |
| Eli Lilly and Co | 407 | 42.3 | 37% |
| Procter & Gamble Co | 367 | 24.5 | 9% |
| Mastercard Inc | 354 | 28.4 | 19% |
| Chevron Corp | 296 | 10.8 | 1% |
| Merck & Co Inc | 298 | 15.7 | 19% |
| Home Depot Inc | 289 | 17.7 | 6% |
Source: Refinitiv, Wilsons.
Cyclical Risks Elevated but Long-term Growth Potential still Demands a Premium Valuation
The equilibrium long-term bond yield, prospects for the corporate tax rate, the path of the US$ and, most importantly, the earnings performance of the US corporate sector are all considerations in assessing the likely performance of US equities over the next 5-10 years.
Focusing on the shorter term, the main risk over the next 12 months or so is a significant cyclical slowdown in the US and global economy (i.e., a recession).
This risks significant downward revisions to current earnings expectations for 2024 in particular. The consensus is currently assuming 12% earnings growth.
Of course, cyclical earnings risk applies to all countries and regions. We think US earnings are likely to be relatively resilient versus the rest of the developed world, but it is still a significant risk factor to monitor.
We tend towards a view that the economic slowdown will not be overly severe, particularly in the US. However, we continue to monitor the validity of our central case view. The current US reporting season was encouraging but the debate around the amount of earnings risk in forward estimates remains pivotal. While downside economic and earnings risk is an important tactical (6-12 month) call, it is unlikely to change the longer structural growth story behind the US market. In our view, the longer-term outlook for the US equity market (3 years plus) remains constructive.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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