The US equity market has pushed on higher this year fuelled by the AI boom, and investors are beginning to question whether the environment resembles the latter half of the 1990s with its dotcom boom (and subsequent April 2000 bust). While valuations in certain areas look stretched, the broader market picture is more mixed.
A blotchy picture
Concentration risk means the Mag 7 drives the Tech Sector, which drives the US equity market, which drives world equities. But concentration risk is a choice, not an obligation. If we zoom out and look at all the different parts of the equity market, whether by regions, sectors or factors, the landscape is more blotchy.
Valuations in the tech sector do indeed look stretched, but with earnings growth, investment growth and rate cuts, it could continue to run. Meanwhile in other sectors such Utilities and Healthcare, factors such as Value factor, and regions such as UK equities and particularly UK equity income, valuations are from stretched and in fact looking very reasonable. Selectivity within the equity allocation is therefore key to achieve a balanced between market risk (beta), concentration risk and diversification.
Braced for volatility
Given the stretched nature of US equities and their importance to world equities, investors should be braced for volatility. Markets are weighing up each data point to consider the alternate scenarios of a continued run up (earnings growth, rate cuts) and a shake down (economic slowdown, valuation compression).
Valuation expansion has been a key driver to the equity market run up. When judged on past earnings, US equities – and especially the tech stocks – are expensive. Forward-looking metrics capture the impact of strong expected earnings growth – if it can be delivered. The difference between these backward- and forward-looking views lies at the heart of the uncertainty around the market at the moment. If we were to consider the equity market valuations as being stretched, frothy or a bubble, then in our view, the market is still in the stretched zone but has not yet tipped into a bubble, and moreover this is only regarding the tech sector. The blotchy picture of the rest of the markets shows there is plenty of more attractively valued exposures to be had.
Echoes of the mid/late 1990s
So why is the tech sector running up so hard? The comparison with 1998 is informative. Back then, markets had already been lifted by the innovation of the internet and related productivity gain expectations. Also in the mid/late 1990s, following the LTCM hedge fund and Russian debt default shock, the Fed started easing rates, providing further support. If drawing comparisons today, there are some parallels: a recent external shock (tariffs), a Fed easing cycle, and a productivity step-change. A combination of these could provide support for equities to move even higher, with less richly valued sectors playing catch-up.
Too much or too little FOMO?
FOMO risk can be dangerous, but no FOMO can be costly. Having too much exposure to the most richly-valued parts of the market creates greater downside risk, yet stepping aside too early can be equally costly. Many investors who exited the equity market prematurely in the mid 1990s missed significant gains that occurred before the eventual peak in March 2000.
Importantly, bubble conditions typically require everyone to be fully invested, and that is not the case today. Large amounts of cash remain on the sidelines, and fear of missing out has not yet drawn these investors in. This suggests that, barring a negative shock, equities may still find room to run higher. Repeatedly calling a top too early can create an expensive opportunity cost.
UK Gilts and Sterling Risk
Turning to the UK, the upcoming Budget is prompting a keen focus on potential changes to both personal and business tax. While individuals and business owners consider how any adjustments may affect them, the broader economic impact is more likely to impact long-dated Gilts and Sterling. A loss of confidence in the Government’s fiscal outlook or expectations of slower growth would likely push Gilt yields higher and weaken Sterling. A more positive outlook would have the opposite effect. Either way, investors should be ready for volatility in these markets. It is worth noting that the Budget has little relevance for UK large cap equities and no material bearing on global equities, which remain dominated by the US outlook.
Summary
In conclusion, the US equity market may be stretched but not yet a bubble, and the outlook rests on company earnings, shifts in interest rate policy, and the realisation of AI-driven productivity gains. Concentration in US equities and indeed tech is a choice not an obligation – constructing a balanced approach to equity exposure means considering more sectors, factors and regions.
For investors, the priority should remain a well-balanced financial plan that supports present and future spending needs while keeping long-term growth assets invested, liquid, and diversified across sectors and asset classes.
By Henry Cobbe, Director & Head of Research, Elston Consulting
Photo by Kind and Curious on Unsplash
