The other default risk: US equities

Importantly, this outperformance also feels more significant because it has come alongside a great deal of anxiety about growth outside of the US and pressures in the emerging world. This is somewhat different from the experience of the last decade, in which we have been used to global equity markets falling together in more painful periods.

This is partly illustrated in Figure 2 below. The green bars show the number of weeks in each calendar year where the price of both the US market and the rest of the world (MSCI AC World ex-US) fell by more than 1%. The orange bars show weeks in which the rest of the world declined by more than 1% and US did not, and the purple bars where only the US market fell.

Since the financial crisis, it has been more common for the US and the rest of the world to fall together in larger down weeks than for either to fall independently. However, so far in 2018, the US market has been somewhat immune to weakness elsewhere. It has been more common for the rest of the world to fall on its own.

The long-term trend: relatively justified

This dynamic is totally understandable given prevailing news flow. The recent outperformance of the US market (shown by the dark line below) reflects a longer trend, one that is not behavioural in nature.

While some have argued that investors have fallen in love with tech stocks, or been fearful of cheaper valuations in other parts of the world, the real story is that the US has simply been better at delivering profits since the financial crisis (red line below).

We should therefore be too wary of trying too hard to define this outperformance as a sign of bubble-like behaviour. However, we should always be looking for signs of shifting risk perceptions. In particular, could it be the case that a ‘bubble’ emerges in the US equity market, not because investors become over-excited about the upside in US equities, but because it comes to be seen as the ‘default option?’

Risk perceptions, fragile beliefs, and bubbles

Many have been describing the US equity market as a bubble for some time, largely based on valuation metrics, and in particular the Shiller p/e (which has various issues of its own, and was set to ‘cheapen up’ this year even if there hadn’t been any tax cuts or profits growth).

It is certainly the case that a notable gap has opened up in relative valuations between the US and rest of the world.

This in itself could suggest lower prospective returns than investors have enjoyed in recent years, but is not in itself indicative of vulnerability to a more imminent collapse. For that we need to consider the nature of market beliefs.

For those who believe that bubbles exist (and many don’t, at least in a form that we can make money out of) there is an implicit acceptance of the role of human psychology in markets. Those who try to characterise how bubbles form (this is a good summary of approaches) use terms like ‘excited,’ ‘euphoric,’ ‘exuberant,’ or ‘manic’.

Asset prices move when collective beliefs change en masse. This may be because the facts change, but many theories of why bubbles form and then burst imply that it is because beliefs were fragile in the first place. Investors, motivated by the returns that have just been delivered, either don’t really believe in the fundamental story behind an asset, or convince themselves that only an extremely optimistic scenario is possible. Value metrics alone provide only a limited insight into the role played by sentiment.

A fragile belief in safety?

Is it possible that beliefs can also be fragile, not because of excessive optimism or return-chasing, but simply because an asset is seen as ‘the only game in town? In a world of worries about China, trade wars, emerging markets, and the impact of rising rates on low yielding bonds and other assets, some language and price behaviour of late has implied that some see the US equity market as the only port in a storm. This sentiment can be heightened in a world of actual or de facto benchmarking. With the US market such a large part of the global equity universe, the pain of not owning it or be underweight in phases such as we’ve just experienced is arguably increased.

This can be dangerous. If investors come to see the US equity market as a ‘place to hide’ they may be less inclined to stay the course when they are reminded of risk. Despite the strong performance of the US equity market this year, it is worth remembering that things felt very different in the first three months of the year; it only took the slightest sign of wage inflation to prompt material weakness in February and even the FAANGs have shown signs of vulnerability.

Today, there is much that needs to change for sentiment toward the US to become anything like that seen in the tech bubble (or in bitcoin at the end of last year). But attitudes can change quickly (consider the positive outlook many had on emerging markets at the start of this year). Should investors begin to hold an asset for its apparent safety (or lack of alternatives) then it can be the first step towards more dangerous complacency.