Global valuations: A rubber band poised to snap

Author: Matthew Poterba, CFA

History shows that returns are greatest when capital is scarce. But investors need to also realize that risks escalate when there is a glut of capital.

Valuation alone may not be a reliable short-term timing indicator, but crowded and overvalued markets have a greater risk of disappointment. Today, investors are generally ignoring global stocks and have increasingly crowded into a handful of very expensive US stocks. Because valuation is a prime determinant of long-term returns, these ignored market segments stand to benefit as sentiment begins to normalize.

Investors are crowding US equities

Many portfolios reflect what has worked best in the last decade rather than what may work going forward. Chart 1 shows the average equity positioning of tactical and strategic asset allocation strategies at six selected large investment firms. Relative to the global equity market, these strategies are significantly overweight the US at the expense of International Developed and Emerging Market stocks.

RBA’s Global Equity ETF Strategy appears positioned dramatically different than consensus. We are meaningfully underweight the US and see significant opportunities outside the US.

Most stocks around the world look cheap

During periods of heightened investor interest, such as the current focus on the 'Magnificent 7,' stocks’ valuations can soar beyond sustainable levels. Conversely, less popular markets may be undervalued. Over longer time horizons these valuation extremes typically correct as market conditions stabilize and investor sentiment adjusts. Equity valuations tend to behave like a rubber band, heavily influenced by investor psychology and sentiment.

Although these reversions to fair value may not occur overnight, valuations do act as an anchor – gradually pulling stock prices toward their intrinsic value. Therefore, this would suggest that US market segments with the richest valuations today are likely to underperform over time. Similarly, undervalued US and international market segments are poised to rise as depressed valuations revert higher toward more normal levels (Chart 2).

US Stocks: A Tale of Two Markets

While the US market appears expensive on the index level, aggregate market statistics hide what could be a historic range of valuations. The ‘Magnificent 7’ dominate standard indices and look very expensive, and their weights in the major indices skew index valuation upward. Yet the vast majority of US stocks are relatively cheap. This stark valuation bifurcation has gotten more pronounced throughout 2023 (Chart 3).

Looking past the expensive ‘Magnificent 7’ reveals many undervalued opportunities across the US and international markets. This divergence highlights potential risks of crowding into already expensive stocks and underscores the prospects of overlooked areas. As valuation differences normalize, capitalizing on these out-of-consensus opportunities may reward investors willing to deviate from the herd.

It's impossible to predict when the valuation rubber band will contract (or snap?). However, the glut of capital rushing to such a small universe of stocks strongly suggests the universe of investment opportunities is much broader than simply 7 stocks.