Beyond USA Exceptionalism: Inevitable Reckoning of Overvaluation

US equities delivered spectacular performance in 2023-24, and outpacing global markets by a long mile. Taiwan was close, but upon closer scrutiny, its gains are driven by large-cap stocks that also play a pivotal role in supporting the strength of the US economy. Through a series of charts, we highlight evidence that US equities may have overshot, suggesting that a more cautious stance is warranted at this juncture. The age-old adage, "When the US sneezes, the world catches a cold," remains as relevant as ever. In this context, we explore the potential near-term implications for Malaysian equities.

US Equities Had a Resounding Year

US indices have posted strong gains in 2024, with the technology-heavy NASDAQ and S&P 500 leading the charge. In contrast, the broader DJIA and Russell 2000 saw more modest returns, which are comparable to the performances of Malaysia’s main indices (refer to Chart 1). The total market capitalization of all US equities surged by 22.8% YoY in 2024, building on a solid 22.9% rise in 2023 (refer to Chart 2). This consistent growth underscores the resilience and strength of the US equity market over the past two years. 

The US Has Taken the Centre Stage Since Late 2023

Chart 3 provides a comparison of the total market capitalization of equities market in the US, Malaysia, and the World, using 2004 as the base year. Over the past 21 years, the US has emerged as the standout performer, delivering a CAGR of 7.6%, ahead of the global average of 6.9% and Malaysia's 4.6%. While the US market closely tracked the global growth rate since 2009, this pattern was decisively broken in 2023, with the US now significantly outpacing the rest of the world to firmly establish itself as the dominant equities market. 

Danger Signs are Lurking

1. Concentration in the US Market has Reached a Record High

The US now accounts for around 75% of the MSCI World Index (refer to Chart 4) — a level not seen in recent times, but one that was the norm during the 1950s to 1970s. Back then, Europe and Japan were still recovering from the aftermath of WWII, while much of the rest of the world was dominated by state-owned enterprises with minimal stock market participation.

From a global benchmarking standpoint, fund managers are compelled to maintain a significant overweight in US equities to track the index and deliver competitive returns. This helps explain the strong performance of US stocks, but it also raises the risk profile—particularly in terms of concentration and volatility—given the relatively small pool of stocks that are driving this performance.

The market capitalization of all US equities exceeds all other global equities combined (refer to Chart 5). This phenomenon started on 12 October 2024 and remains intact to this day. It is mind boggling that one country can hold such sway given that global securitization rate is at an all-time high

2. Magnificent 7+1 are Distorting Reality

The "Magnificent 7+1" —Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta, Tesla, and Broadcom—have delivered an impressive average year-on-year gain of 51.9% in 2024 (refer to Chart 6). If we exclude these eight stocks, US equity returns for 2024 would have been a much more modest 14.7%. These eight stocks are responsible for 55% of the performance of the entire US equity market. 

The combined Market Capitalization of the Magnificent 7+1 stocks now stands at a staggering USD18.7tn. This represents 30% of the total US equities market and 15% of global equities Market Capitalization (refer to Chart 7), growing from 24.4% and 11.1% respectively at the beginning of 2024. Yes, you read that correctly—just eight stocks account for 15% of the entire world’s market value.

This underscores the outsized influence the Magnificent 7+1 now wield over both US and global markets. Should any of these stocks experience a setback, the ripple effects would be felt across the world. Never before in the history of capital markets have so few had such a profound impact.

3. Fear of Inflation Returns

US Treasury yields have been climbing following the Federal Reserve Chairman's comments that there may only be two rate cuts in 2025, versus the market's expectation of four. This has reignited inflation concerns, compounded by worries over the ballooning US debt and the need to issue substantial amounts of new Treasury securities of up to USD7tn to finance huge deficits. Furthermore, the Fed’s ongoing quantitative tightening, aimed at reducing its Treasury holdings, has exacerbated pressure on yields. Consequently, 10- year US Treasuries are now trading above the Fed's Effective Federal Funds Rate (EFFR) of 4.33%, with investors demanding higher yields to offset the increased risks.

Should this trend continue, the higher yields are likely to weigh on US equities, potentially derating in tandem with the rising risk premium. As we have pointed out before, any developments in the US are poised to have significant spillover effects on global equities.

4. Retail Participation is at an All-time High

US households' allocations to equities have reached record levels, currently at 43.4% (refer to Chart 9). This rise coincides with a surge in off-exchange trading, with the latest reading of 56% of total equity volumes, a new all-time high (refer to Chart 10). This trend is a clear indication of a day-trading frenzy, with retail investors likely playing a significant role in driving this activity.

This offers a plausible explanation for the prevailing bullish sentiment and the market’s apparent indifference to negative news. Retail investors, driven by herd mentality, often follow the crowd, ignoring the time-tested principles of fundamental analysis. Worse still, they tend to reinvest all their gains, fuelled by greed and overconfidence in the pursuit of even greater returns.

As the saying goes, the party continues for now, but eventually, the music will stop, or at the very least, take an intermission. Early investors, sitting on substantial unrealized gains, are likely to lock in profits quickly if sentiment sours. However, the bulk of retail novices will likely ride out the full emotional cycle of the market's inevitable downturn.

5. Valuations are Getting Uncomfortably High

We use the S&P500 index as a proxy to US equities. The latest indicators are mixed, the 1-yr forward PE, P/FCF, and P/BV are in overvalued territory. However, the gearing ratio, net income margin, and ROE are at very healthy levels.

Composite Z-score Affirms the S&P500 is Pricey

The Z-score is a statistical measure that quantifies how many standard deviations a value is above or below the average. A positive reading infers that it is expensive while a negative reading infers it is cheap relative to its history.

We compute the composite Z-score by averaging six key valuation metrics, as outlined above. With a score of +0.7 (refer to Chart 17), this suggests that the S&P500 Index is in overvalued territory. We think the prevailing trend is eerily mimicking the “.com” era bubble of 1998-2000 whereby it peaked at 1.1x.

Comparison Against Global Peers

When compared to major global stock indices, the S&P 500 is notably expensive based on traditional valuation metrics such as P/E, P/CF, and P/BV (refer to Table 1 overleaf). While the US stands out with a superior ROE against the peer group, this figure is distorted by the widespread use of share buybacks by US corporations (refer to Chart 18). The US regulators provide significant tax incentives for buybacks, and management often prioritizes this over dividend as a mean to reward shareholders. The trend in equity issuance is net negative, as companies repurchase and cancel their shares, which reduces equity value while ‘artificially’ boosting ROEs. 

Conclusion

US equities are expensive, both in absolute and relative terms. Our composite Z-score, which incorporates the key valuation metrics most favoured by fund managers, indicates that it is in overvalued territory and dangerously mimicking the .com era frenzy. When compared to other major global indices, the analysis further confirms that the US market is trading at elevated levels.

Yet, the term "bubble" remains conspicuously absent from the lexicon of market forecasters. This reluctance is understandable, given the relentless market momentum and the US economy stands out as the clear leader among the developed nations, many of which are grappling with their own economic and domestic political challenges. There is currently no compelling catalyst on the horizon that could propel other developed markets to outperform the US in the near term.

The reality is, sooner or later, a correction is coming, and this should not surprise savvy investors. Assuming such a correction materialises, the US dollar will strengthen as investors unwind their positions and seek safety in cash. The USD is the go-to currency during times of uncertainty, no matter how much the BRICS countries bang on about de-dollarisation. Thereafter, fixed income instruments will appreciate due to demand from yield-seeking investors. This was the general observations in the past two major crisis of Global Financial Crisis (GFC) 2008-09, and the COVID-19 pandemic.

Source: BIMB Securities Research - 8 Jan 2025