How to diversify amid sky-high US ratings

Bullishness on US exceptionalism and the potential for solid gains in a deregulated second Trump term has distracted from the concentration risks at the top of the US market and question marks over elevated valuations. Investors should by no means ignore the US and its high-growth options, but diversification is key given the potential for a near-term boost for non-US markets. 

Daniel Rasmussen at Verdad argued this week that "there’s a strong reason to expect a convergence" in valuations between US and international equities and that it's time for investors "to favor international over US-listed stocks, despite their terrible relative performance over the past decade".

His analysis found that the biggest factor for the valuations divergence is not driven by investment fundamentals but the simple fact of being listed on a US exchange. High-growth tech is of course part of the pricier valuation story, but having a higher proportion of sales in the US actually delivers a cheaper valuation, with the Magnificent 7 (the stocks which underpin the high rating of the S&P 500) taking 50 per cent or less of their sales in the US. 

The S&P 500 has been outperformed in the year-to-date by other bourses, with the index's rise of 3 per cent bettered by the FTSE 100's gain of 4 per cent and the Stoxx 600's 5 per cent increase. The US index trades on a significant premium to international market peers - its 22 times forward earnings rating is almost double that of the FTSE 100 - and investors have moved into other markets of late as they diversify over concerns about tariffs under the new administration and high bond yields. 

The January edition of Bank of America's global fund manager survey found that there had been the second biggest increase in the allocation to European equities for a quarter of a century. Investors rotated out of US stocks, which moved from a net 36 per cent overweight position in December to 19 per cent overweight in January. They moved into Eurozone stocks, which saw a 26 percentage point increase to take them 1 per cent overweight, the biggest move since 2015.

Looking at economic prospects, that might seem surprising. After all, it was confirmed this week that the Eurozone economy stagnated in the fourth quarter of last year. 

Analysts at Panmure Liberum pointed out a couple of reasons for taking a bullish stance on Europe. They posited that earnings growth could outstrip GDP growth - helped by the "diversified geographic exposure of large-caps, which rely heavily on US and Asian demand" - and the fact that large-caps are "particularly cheap at current valuations".

The doom and gloom narrative about the UK - the Bank of America survey found that investors are net 16 per cent underweight UK equities - can also distract from some solid opportunities. As we discussed recently, UK small cap shares have outperformed US blue chips over the long term. And before Christmas, we looked at the positive valuation case for some major UK players including Marks & Spencer (MKS) and National Grid (NG). 

A big question is when the convergence Verdad expects happens (if it actually does). Capital Economics chief markets economist John Higgins expects the S&P 500 index to rise to 7,000 points this year, from its current position of just over 6,000 points, but he anticipates "a significant correction" in 2026 once its valuation reaches "the sort of level at which it peaked before the dotcom bubble burst".