The Overvaluation of US Equities

Disclaimer: Please note that all content and information in this blog are for educational and informational purposes only and should not be taken as professional investment advice.

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An Unpopular Opinion: Overvaluation of US Equities

Most people would have heard of ETFs by now. And many have invested in it or are looking to invest. With many people looking to add positions in US equities, it will take a major event to trigger a US market crash. And when it happens, it will likely happen really fast. In this age of information technology, markets are getting more efficient, and this means markets are quicker to price in changes, whether good or bad. As such, markets will remain volatile and are likely to become more volatile over time. And this means as investors, we need to be able to stomach this greater volatility.

In conventional finance, volatility = risk, and risk must be commensurated with returns. Following this, as markets get more efficient, they get more volatile, since changes are priced in quicker. So, markets are riskier due to greater volatility, and therefore must give higher returns to commensurate for the higher risk. 

Sounds logical but herein lies the issue: Conventional Finance does not consider Behavioural Finance.

Market crashes cannot be explained solely by conventional finance. It takes behavioural finance to explain market phenomenons like crashes. Even so, behavioural finance alone is unable to explain market phenomenons fully, but at least we have some understanding of how and why such phenomenons occur.

Market crashes occur when the number of sellers overwhelm the number of buyers. Conversely, market bubbles occur when the number of buyers overwhelm the number of sellers.

Currently, the US market is not in a bubble, and it is clearly not in a correction or crash either. However, the US market is definitely much closer to being overvalued than undervalued.

From a behavioural finance perspective, there is a lot of interest or "hype" surrounding US equities because of the phenomenal returns delivered by the Magnificent 7 in recent years. A large part of the US market rally is driven by these 7 stocks. It is unsurprising since like many things in life, it follows the 20/80 rule, which in simple terms means that 80% of the outcome is driven by 20% of the factors. 20% US stocks drive 80% of growth. And historically over the years, the bulk of the returns of the S&P 500 have been driven by a handful of companies.

Because of the exceptional returns delivered by the US market via the Magnificent 7, it is unsurprising many people are pouring funds into the US market via US ETFs. However, the issue happens when everyone is pouring money into the same or similar class of assets — US equities, which are currently largely made up of technology stocks.

While there's absolutely nothing wrong with investing in tech stocks — all the more so since it is a sunrise industry especially with the AI boom, from a behavioural finance viewpoint, it is risky as everyone is buying into it. The record high inflow of funds into US ETFs is both comforting and worrying at the same time.

Why?

It indicates a healthy economy and strong market optimism which is comforting. But for some, it may be worrying because it is rarely a good sign when everyone is buying the same asset. While the US market is huge, the inflows are not small as well. The size of the US market alone cannot justify the huge inflows into it, because a large-sized market is definitely not immune to market bubbles (as we have seen in the past in the 2001 Dot Com Bubble). In fact, the bigger the market size, the riskier the bubble because the impact would be devastating.

The fact that everyone is buying the same asset class makes that asset inherently risky. It may not be risky initially, but the fact everyone is investing in it (or show really strong interest in it), inevitably makes the asset class riskier because its price gets bidded up as there are many buyers but few willing sellers.

Recall how a market bubble occurs: when the number of buyers overwhelm the number of sellers. While we aren't witnessing this now, I believe we are closer to it than to a fairly valued market, especially if the US market continues rallying like there is no tomorrow.

FOMO

Many people are pouring funds into US ETFs without thinking twice, which naturally bids up prices. And those who missed the rally are now trying to "catch-up" by buying into the US market at even the slightest correction or drop. 

Just a 2-4% drop is sufficient to cause hoards of investors flocking to snap up shares. These are early signs of a potential bubble. As we continue to head into territories of higher valuations, it will be unsurprising if the US market enters a correction or bear market much earlier than everyone thinks, or worse still, the bursting of a bubble.

No one can tell for sure, but it is clear the US market is not cheap and hence not as lucrative as an investment it was in the past. It can still provide respectable returns, but one should not expect the  10-15% annualised returns seen over the past years or decades. Those were likely an exception rather than the norm.

Closing Remarks

Personally, I believe an annualised return of 7-9% in US equities is more sustainable moving forward over the next few decades. Investors should not invest in US ETFs and blindly expect 10-15% annualised returns as though by magic. The past decade or so was a period of exceptionally low interest rates, and where high returns were also largely contributed by the significant market sell-off in 2009. This depressed equity prices, leading to many bargain buys in the early 2010s. And when the market recovered fully from the GFC, it rebounded strongly, leading to exceptionally high returns in recent years. 

In short, the 10-15% annualised returns delivered by the US market in recent years is not the norm but an exception.

Many new investors may believe it is the norm and plan their finances based on this exception. As such, it pays to be conservative in our estimates. Expecting the US market to deliver 7-9% annualised returns is definitely more realistic and sustainable, and therefore will be a much wiser decision for investors looking to plan long-term. 

Any returns above it should be taken as a bonus rather than an expectation. We should plan for the worst and expect the best. Erring on the side of caution will always allow you to uncover unforeseen pitfalls and your blindspots.

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Disclaimer:

The content and information provided on this blog is solely for educational and informational purposes, and should not be construed as financial advice. The accuracy or completeness of the content and information provided in the blog cannot be guaranteed. Before making any investment decisions, it is important for readers to research and carry out independent verification of the information provided, or consult with a qualified financial professional. No warranty and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of actions taken based on the ideas or information found in this blog.

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