Investors need to get wise to a new world order.
Don’t count on a perpetual US bull market.
In early 1989, Japan’s 45% weighting in the MSCI World index was the largest of any region as easy credit-fueled speculative borrowing to invest in equities and real estate.
A global investor would have done well to ignore the benchmark weighting back then; over the next four years, the MSCI Japan index halved.
But imagine trying to explain that decision to clients.
Go with the flow?
They would surely have succumbed to recency bias and pointed to the market rising 500% rise over the prior five years – an annualised 42%.
Or they might have pointed out that business students around the world (like me) were studying Japanese corporate practices – evidence that Japan was a winning nation which would keep winning.
Whereas all that a value driven sceptic had to offer was that valuations stood at 50x earnings, driven by a sense of euphoria.
The rest is history and today Japan’s weighting is only 5.4% in the World index.
By contrast, today US equities comprise an overwhelming 72% weighting of that same benchmark. And once again we have lofty valuations and a sense of euphoria.
Coming around again
So could it be wise to once again ignore the benchmark when allocating your investments? We think so and that’s why the Ranmore Global Equity Fund has only 20% exposed to select US equities.
You might argue that the index isn’t trading at 50x accounting earnings like Japan in 1989.
Except, given the high capex spend underway, the Mag 7 is currently trading at 58x free cash flow (FCF).
Those seven companies have a collective market cap of $22tn and generated $385bn FCF (our preferred measure) over the past year, far lower than net income of $568bn.
Go further and deduct stock-based compensation – a real cost to shareholders – that number rises to 77x FCF.
Beyond tech
And it’s not just the tech giants. Even mainstream giants like Walmart and Costco are trading at 63x and 53x trailing free cash flow.
At a times of extreme valuations it often pays to think deeper than convention and be decisive – just like back in 1989 in Japan – because valuation is only one of the risks facing US equities.
Recent bankruptcies of First Brands and Tricolor appear to show weaknesses in private credit lending, with J.P. Morgan CEO Jamie Dimon recently warning of more ‘cockroaches’ that might come out from under the floorboards.
Evening in America
All this is set against a rather grim social and political backdrop in the US, starting with a government which remains shutdown, undoubtedly affecting economic activity.
The rising levels of authoritarianism and intertwining of business and government taking place in America, together with dwindling central bank independence, has historically demanded valuation discounts around the world in places such as Russia, Turkey and China.
We’d also argue that the deployment of National Guard troops and ICE agent activity in cities around the US equates to martial law which has historically warranted discounts in countries, as we saw last year in South Korea.
Irrational exuberance returns
At the same time as there are many signs of speculative euphoria including some 900 leveraged (and, we’d argue, dangerous) ETFs, accounting for 1/3 of new issues.
The adoption of One Day to Expiry options has exploded and currently account for more than half of all S&P500 option activity.
Now some may argue Buffett-like that you should never bet against the US – and that been the right decision for the past century.
But things change. Going back a further 90 years from 1989 Japan, the UK was the largest market in the world with a 24% weighting. Today that number is 3.5%. I’m sure back then there were some investors saying ‘never bet against the UK’.
What happens when?
No one knows what the eventual catalyst will be that will burst this bubble, nor when it will burst.
But history has repeatedly shown us that the odds of generating attractive real returns over the medium to long term are not on your side when you pay high valuations.
The US’s ‘tomahawk turmoil’ has perhaps led to acceptance by global politicians that the rest of the world can no longer rely on America.
Maybe it’s time for global investors to do the same.
Sean Peche is a value investor with a Citywire AAA rating who manages the Ranmore Global Equity fund (Irish Ucits).
In the three years to the end of September, Peche ranked first in his 68-strong Global Value peer group, with his fund returning 108% against a sector average of 47.6%.
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