For investors – and many others – 2025 has got off to an interesting start. In a few short weeks, investors have had to contend with questions over the sustainability of government debt loads, the ending (or at least pausing) of the Federal Reserve’s short-lived interest rate cutting cycle, numerous threats to international trade flows, the apparent imperial ambitions of the ‘leader of the free world’, and the emergence of a purported technological breakthrough in China that threatens to pull the rug from beneath the feet of the US tech giants that dominate the global investment landscape.
While each of these developments merits careful consideration, it can at times seem impossible to see the wood
for the trees. At such times, we find it pays to focus on first principles, and to use the conclusions to anchor our
investment views amidst the sturm und drang. In this update, we go back to basics to take a considered look at the current market environment beyond the excitable headlines.
Paramount among our principles is the notion that valuation is, and must always be, the decisive factor in the success of any investment. No matter how secure the asset or how spectacular the growth prospects, the more an investor pays for it now, the less scope there is for the price to rise in the future.
We are therefore put on alert by the recognition that the US stock market – which currently accounts for an extraordinary 66% of global equity indices – has rarely been more expensive (Fig.1).
Fig.1: As measured by the Cyclically Adjusted Price-Earnings (CAPE) Ratio, the US equity market is in the top 10% of its historic range
The Cyclically Adjusted Price-Earnings Ratio compares the price of an investment to its inflation-adjusted earnings over the previous ten years. The aim is to produce a more stable measure of value compared to ratios that rely on only one year’s earnings, and which can be volatile and misleading, particularly at times when the economic cycle is turning
In a world in which business (and government) leaders actively seek to ‘move fast and break things’, some would argue that our insistence on the importance of valuation is outdated. Our response is two-fold. First, we note that there has, over the course of several economic cycles and throughout numerous bull markets, bear markets, manias and panics, been an enduring relationship between valuations at the point of investment and the long-term returns that investment subsequently yields (Fig.2). Second, though we recognise that capital light technology companies deserve to trade at a premium to the slow-moving industrial heavyweights of yore, we fail to see that this negates the conclusions drawn from basic investment theory and half a century of evidence: that buying at an extraordinarily high valuation demands that the investment surpasses the extraordinarily ambitious expectations embedded in those valuations. Empirically, neither the fastest growing nor the largest companies have tended to hold onto their crowns for long.
Fig.2: Historically, there has been a persistent relationship between valuations at the point of investment and the returns investors have earned over the subsequent ten years
The red dot marks the point on the historic regression that corresponds to the current valuation of the US equity market. It implies investors should expect very low returns from US equities over the next decade.
The implications of the relationship between starting valuations and future returns should, at the very least, make investors sit up and pay attention to the extended valuations at which US equities are currently trading. If the historic relationship were to have complete predictive power, current valuations (marked by the red dot in Fig.2) would point to annualised returns of less than 3% over the next ten years. Even the best-case historic returns starting at similar valuations offer little hope for annualised returns above 5% over the coming decade. Investors expecting equities to continue their recent rapid ascent have history against them and, as legendary investor Sir John Templeton once remarked, “the four most dangerous words in investing are ‘this time it’s different’”.
So if equities are expensive and prospective returns meagre, how should investors respond? Once again, we return to valuations – this time comparing equities to bonds. After a decade or more during which bond yields were anchored by near-zero interest rates, yields rose sharply in 2022 to levels that, we believe, present a challenging hurdle against which prospective equity returns should be judged.
One way to approach this task is to consider the equity risk premium currently available to investors. This idea provides a gauge of the level of compensation investors are demanding to assume the additional risk of investing in equities versus the comparative security of high-quality bonds. Viewed in this light, a high equity risk premium can be understood as an indication that investors are relatively risk averse, while a low equity risk premium reflects buoyant sentiment and a more cavalier acceptance of risk. Once again, we note with caution that the equity risk premium for the US stock market is at levels last seen as the dot-com bubble inflated and subsequently burst (Fig.3).
Fig.3: The Equity Risk Premium has moved sharply lower over the past two years, and is now at levels approaching those seen in the dot-com bubble
The Equity Risk Premium compares the forward earnings yield on equities (expected earnings per share expressed as a percentage of the current share price) to the yield on the ten-year inflation-linked government bond. Investors in equities are bearing more risk and should demand a higher yield – or a “premium” – in return. A declining equity risk premium indicates that equity investors are willing to accept less compensation for the additional risk they are bearing.
Unsurprisingly, as the dot-com bubble deflated global bonds meaningfully outperformed US equities. What may raise an eyebrow, however, is the point at which investors would have been better off switching from equities to bonds. Even though the stock market had a further 50% to climb before it reached its decisive turning point in September 2000, investors following a three-year buy and hold strategy would have been better off in bonds as early as September 1998. We suspect, however, that amid the widespread euphoria surrounding the nascent internet, few investors would have been willing to make this switch – and those few that did would have required an iron will not to recant and reverse their decision as the stock market scaled ever greater heights over the following two years.
This, apparently, is exactly what Sir Isaac Newton did during the South Sea Bubble of 1720. In April of that year, he is reported to have sold his South Sea Company stock at just over £300, pocketing £7,000 and a 100% profit while declaring “I can calculate the motions of the heavenly bodies, but not the madness of people”. Yet just three months later, having seen the share price rise towards £1,000, Newton was back purchasing stock, a decision that was to cost him £20,000 (roughly equivalent to £25million today) when the bubble burst. Evidently, the fear of missing out can be a powerful and destructive force.
What, then, does the evidence suggest a disciplined, valuationaware investor should do? Firstly, it argues for leaning away from expensive equities where the potential for future longterm returns appears, at best, limited. Secondly, it suggests investors may be well-served by high quality bonds offering yields that compare favourably to the prospective returns associated with prevailing equity market valuations and confer a degree of security in the event these valuations suffer a sharp and damaging correction. Lastly – though perhaps less obviously – it advocates for healthy doses of humility and patience. While it might be tempting to make an all or nothing bet one way or the other, the consequences of being wrong – or even just early – can lead an investor to abandon their principles and make irrational decisions to the detriment of their long-term financial security.
We therefore continue to recommend portfolios that are meaningfully but not aggressively underweight equities, and that contain large allocations to high quality bonds. We have the capacity and the agility to reduce equity allocations further in due course, if required. At the same time, we will persist in our efforts to make sense of economic, corporate and market developments, and to search for opportunities to take on risk where adequately compensated by the prospect of appropriate returns. At present, we find few such opportunities. We believe, however, that sticking to our principles will leave us well placed to take advantage as and when they eventually arise.
