Is the golden era for US shares coming to an end?

The investment focus naturally shifts to the US on Independence Day but more so than ever this year as the completion of elections here today and in France at the weekend moves the political spotlight across the Atlantic too.

A third reason to turn our attention to the US market this week is the end of a remarkable first half year in which Wall Street has continued to lead the charge. The first six months of 2024 has been the 21st best first half year for US shares since 1900, according to analysis from Goldman Sachs. Over the past 12 months, the performance of the S&P 500 has been roughly twice as good as its counterparts in Europe, Japan and Asia.

Global equities have not had a 5% peak to trough retreat since the correction last autumn, in large part due to the performance of US shares, which account for nearly two-thirds of the total value of the world’s stock markets. There has only been a handful of periods in the past 30 years when we have gone this long without such a pullback in markets.

This is not by itself a reason to worry. In fact, strong first half years often set investors up for a rewarding second half too. Since the beginning of the 20th century shares have only fallen seven times in the second six months after a strong opening to the year. The last time this happened was nearly 40 years ago in 1986. The second half return after a strong first half is higher than the average for all years too.

The relative performance of US shares during the latest market rally should be seen in the context of a longer-run period of much stronger returns for Wall Street than for other markets around the world. The US outperformed other markets from the early 1990s until the financial crisis in 2008 but then it fell further and so had delivered comparable returns to its peers in the 30 years prior to the bottom of the market in 2009.

Since the start of the long post-crisis bull market, however, the US has parted company with the rest of the world. The period since 2009 has been one of unparalleled US market dominance.

To a large extent this has been justified by economic and corporate fundamentals. Not only has the US economy been the world’s largest but its stock market, except for a brief moment during the Japanese bubble in the late 1980s, has also been far and away the world’s biggest. With many non-US companies choosing to list in New York, the value of its stock market has risen over the past 50 years from less than half of GDP to 170% of it. The rest of the world’s markets represent just 60% of global GDP.

The performance of US shares has also been justified by stronger corporate earnings growth. Since the financial crisis American shares have consistently outperformed those in the rest of the world but so too has the profitability of American companies. American market exceptionalism has been a reflection of exceptional American growth.

Indeed, America’s exposure to the ‘growth’ investment style has been a massive boon to US investors. The period from 2009 to the start of the monetary policy tightening cycle in 2022 represented the longest unbroken outperformance of growth over value in the past 50 years. Wall Street has more exposure to the world’s fastest-growing sectors and companies and less exposure to its laggards.

While justified, the success of the US stock market makes it relatively vulnerable going forward, however. In terms of the most widely-used valuation measure - the price-to-earnings ratio - American shares are more expensive than at almost any point over the past 20 years. And they are much more expensive than other markets on the same basis. US shares are priced at more than 21 times expected earnings. Even stripping out the big technology companies, the ratio is over 18. That compares with 13 in Europe, 12 in emerging markets and just 11 here in the UK. There is a negative correlation between the starting valuation of an investment and subsequently realised returns over a ten-year period. Expensive markets on average underperform cheaper ones eventually, even if in the short term a high valuation has little predictive power.

Another risk with the US stock market is its relatively high concentration. To be fair, this is a feature of other markets too, but the issue is more notable in the US. In the year to date, two-thirds of the market’s return can be attributed to just the biggest seven shares. It is possible that these mega-cap companies will continue to dominate, but the US bull market is increasingly dependent on them doing so. Concentration has not been this high since 1929 and that, as we know, did not end well.

The continuing success of the US stock market is also highly dependent on sentiment remaining positive towards the AI investment story. And on the AI winners continuing to be the same companies that investors have identified as beneficiaries to date. The market may have got it right but as the performance of the AI focused stocks and the rest diverges, the overall market risks increase. The positive earnings growth narrative hangs on the 30% growth forecast for the big tech stocks being delivered. The rest of the market is expected to grow profits at a much more modest 5%, and the relative outperformance of the most defensive sectors suggests the risks are to the downside.

It has rarely been sensible to bet against Uncle Sam. Investment success in recent years has largely been a reflection of how much US exposure you have had in your portfolio. Diversification has not served investors particularly well, but I suspect it will from here.

This article was originally published in The Telegraph.

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