1. “Heavy is the head that wears the crown.”
In November, U.S. small cap equities looked to be the biggest winner of the U.S. election. By the end of December, U.S. large cap equities were back wearing the crown they have worn for over a decade.
2. While there was no Santa Claus rally into year end, U.S. equity investors had much to be thankful for in 2024 given double digit returns, led by U.S. large cap equities, which generated a return of almost 25%.
Stocks with strong price momentum, mostly growth stocks, led the way with a return of 46%. Consistent dividend payers were the laggard with a return of 7%.
Source: S&P Dow Jones Indices
3. The valuation gap between U.S. large cap equities and non-U.S. equities is the widest ever.
A sizeable valuation gap is justified as long as U.S. equities can generate much higher earnings growth with less earnings volatility than non-U.S. equity markets.
4. Inflation is a risk to U.S. equity market valuation multiples. The rate of inflation has plateaued above 3%. Any uptick in inflation will likely be a headwind for U.S. profit margins.
The “core” inflation rate (CPI excluding food and energy) remains over 1% above pre-pandemic levels. Second waves of inflationary pressure are also not uncommon throughout history. The Atlanta Federal Reserve Bank’s measure of “sticky price” inflation (think rent, insurance and medical care) has dipped but is still running near a 4% annual rate.
5. A downturn in the rate of economic growth in the U.S. is a risk to both corporate earnings growth and U.S. equity market multiples. Predicting economic growth, especially predicting recessions, is difficult.
One of the proverbial canaries in the coal mine for economic growth and corporate earnings growth is credit spreads. Currently, U.S. high yield corporate credit spreads remain below their long-term average and have not exhibited any signs of an upward surge typically associated with recessionary environments.
6. Another possibility that leads to a compression of the valuation multiple gap between U.S. equities and non-U.S. equities is a sustained improvement in earnings growth, i.e., an improvement in fundamentals, for non-U.S. companies.
China has been dealing with the impact of overinvestment, especially in real estate, as its population has begun to rapidly age. Many local governments are facing declining tax revenues as the real estate sector contracts. China’s banking system may also need a federal government backstop. Europe has been dealing low productivity due to high energy prices driven by poor energy policy, stifling regulation, aging populations, and immigration policies that didn’t provide low-cost labor but have consumed government resources. Both China and Europe have been slow to address the structural issues facing their economies. Neither benefit from easy access to low-cost energy and a large, innovative technology sector, two factors that buttress the U.S. economy/
However, if China and Europe can “stop the bleeding” and demonstrate some semblance of sustained improvement in fundamentals, then the “value” represented by China and Europe will not be a “value trap”. Less bad fundamentals would likely translate into China and Europe equity markets outperforming the U.S. equity markets.