Is the US stock market cheaper than we think?

INVESTING in an index was once a sure-fire way of gaining an exposure to the long-term growth in stock markets while spreading your risk over a wide range of company names.

In many instances, that remains the case today. But it’s not necessarily true. Finland set the marker back in 2000, when Nokia turned into 70% of the Helsinki stock market by value¹.

The dotcom bust that followed resolved the situation. But this event did demonstrate the capacity indices have of becoming unintended risk concentration zones.

Today, the US accounts for a mindboggling 70% of the MSCI World Index and 62% of the MSCI All Countries World Index². Investing in a fund tracking either of these or any similar index essentially means investing in America.

The US stock market itself, in spite of its immense size, has fallen victim to risk concentration. The now familiar “Magnificent Seven” – America’s technology mega caps – have become so large and valuable they serve as an imperfect proxy for the entire S&P 500.

The corollary to these statements is that the S&P 500 is now inextricably linked to the global technology sector. At the end of last month, Apple, Microsoft, Amazon, Nvidia, Alphabet, Tesla and Meta together accounted for around 27% of the index³.

These effects have served investors well so far this year, but only after a dismal 2022. Since stock markets generally seek to discount future events, last year was all about the negative impact of interest rate rises to come. By and large, markets have been buoyed this year by expectations the worst will soon be behind us.

High interest rates tend to have a large effect on companies with the bulk of their expected profits far out into the future. By definition, tech companies growing their earnings consistently each year and independently of the general economic cycle fit this category.

Investors have already demonstrated their willingness to pay a premium for the world’s consistent growth winners. The S&P 500 Index currently trades on around 21 times the earnings its constituent companies are expected to make over the next 12 months⁴.

Rapid year-on-year earnings improvements from large companies such as Nvidia, Meta and Amazon and a partial correction in share prices since August have reduced this multiple from its summer peak.

However, the US stock market continues to trade at a premium to other world markets and its own long term averages. So can we sideline high valuations and a concentration of risk by looking at alternative ways of investing?

The S&P 500 Equal Weight Index harks back in some respects to the Dow Jones Industrials Average which, since its inception in 1895, has been a price rather than market value weighted index. The former index holds each stock in equal measure and rebalances its weightings each quarter.

Investors can buy an ETF that tracks the S&P 500 Equal Weight Index, thereby addressing concentration risk. However, this yields no discernible benefit in terms of valuation since the index also trades on almost 21 times earnings⁵.

Actively managed US funds offer distinct advantages in the current environment. The Dodge & Cox Worldwide US Stock Fund, which features on Fidelity’s Select 50, has a strong leaning towards large and medium sized out-of-favour US companies.

Thus, while Alphabet is currently the portfolio’s top stock, the names that follow – Occidental Petroleum, Wells Fargo and Charles Schwab – take the fund well away from the technology sector.

This portfolio is currently invested in 74 companies, and traded on just 13 times earnings at the end of September, well below the market average⁶.

Smaller companies also have a valuation advantage. According to analysis by T. Rowe Price, managers of the T. Rowe Price Funds OEIC US Smaller Companies Equity Fund – US smaller companies are trading at their lowest levels relative to the S&P 500 Index than at any time since July 2002⁶.

That’s based on the Russell 2000 Index, which tracks the performance of America’s smallest 2000 publicly traded companies, but excluding small-cap biopharma stocks.

You can look at this two ways. Either US smaller companies, which have a greater exposure to America’s grass roots economy, are correctly pricing in a negative outcome for the economy after interest rate rises.  Or that smaller companies now offer investors with a route into the country’s future economic growth at historically cheap levels.

The T. Rowe Price Funds OEIC US Smaller Companies Equity Fund also features on Fidelity’s Select 50 list and caters for investors looking to move down the market cap scale in search of stronger long term growth prospects. The risks are greater but so are the potential rewards.

Watch Tom Stevenson’s latest outlook on the US below.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates.  Select 50 is not a personal recommendation to buy or sell a fund. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.