Heron’s Eye View – Cracks Widening in the Private Credit Market

Until recently, private credit – a purportedly new asset class – has been one of Wall Street’s fastest growing investment products. Companies considered too complex for traditional bank lending or too small to access public bond markets were increasingly turning to specialist private credit lenders for funding. These lenders have historically pooled capital from institutional investors and provided financing to private borrowers, earning above public market interest rates in return. In the space of just a few years, the global private credit market has ballooned to around $3 trillion in size, larger than the US public high‑yield bond market and almost twice the value of the sub‑prime market ahead of the 2008 financial crisis. Encouraged by this success, private credit managers have begun selling products to retail investors.

Though supposedly a new asset class, we suspect there is less to private credit than meets the eye. It is possible that some niche issuers might be willing to pay higher interest rates in return for customised loan terms. However, we think it more likely that, for the most part, the higher yields on offer simply reflect less creditworthy borrowers and significantly reduced liquidity (the ability to buy or sell the bonds at a reasonable price, at will).

A series of negative headlines in the past few weeks suggests the private credit market is beginning to creak. For example, BlackRock has completely written off a private credit loan that it valued at par just three months ago. Other managers have also been forced to write down the value of some loans, with questions emerging around the accounting and disclosure standards of certain large private credit borrowers – and the due‑diligence and valuation practices of lenders – in this unregulated market.

With investors taking note of JPMorgan CEO Jamie Dimon’s warning that “when you see one cockroach, there are probably more” – a reference to the recent high profile private credit backed bankruptcies of Tricolor and First Brands Group – private credit funds have received record redemption requests. This has exposed the liquidity mismatch inherent in selling private loans to retail investors. In response, a number of prominent private credit funds, including those managed by Blackstone, Blue Owl and BlackRock, have suspended redemptions, leaving investors unable to access their capital.

With funding drying up, borrowers needing to refinance their debt – as well as those struggling to make regular interest payments – have increasingly resorted to ‘payment‑in‑kind’ (PIK) loans. These arrangements allow companies to defer cash interest payments by adding to the outstanding loan balance instead, increasing leverage and creating an even larger debt burden to be repaid at maturity – assuming the company survives that long.

Fig. 1: Year-to-Date Returns of Private Market Asset Managers

Fig. 1: Year-to-Date Returns of Private Market Asset Managers

Against this backdrop, listed private market asset managers, particularly those with large credit arms, have seen their share prices fall sharply over the year‑to‑date (see Fig. 1).
Reports of rising defaults and the withdrawal of funding across the private credit market, together with surging oil prices, are reminiscent of conditions seen ahead of the financial crisis. Bolstering the comparison, the role played by banks in providing leverage to private credit managers increases the risk that problems could extend beyond the asset class itself. Though the opaque nature of the private credit market makes it difficult to assess the full scale of the risks involved, recent headlines and their implications are, at the very least, a cause for concern.

We have steered clear of private credit, believing the flood of assets into this part of the market has likely encouraged and masked a lax approach to risk management. Instead, the fixed income component of Heronsgate portfolios is skewed in favour of high‑quality, liquid bonds where valuations are transparent and the risk of default is low.

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Heron’s Eye View – Iran Update

We can debate the reasoning behind President Trump’s decision to bombard Iran, we can speculate about what he hopes to achieve (perhaps extraction rights to Iran’s oil reserves or simply a diversion from flagging popularity numbers at home) and we can contemplate various possible timeframes for, and outcomes of, ‘Operation Epic Fury’. From an analytical perspective, however, this is unedifying. At this stage, there can be little more than conjecture about such key questions as how long the conflict might endure, the extent to which it might spill across the Middle East more widely and what shape a new Iranian leadership might take.

While there are undoubtedly more fundamental questions to answer in the midst of an escalating conflict, our job is to consider the implications for financial markets and to ask how investors should best respond.

Unsurprisingly, energy prices have lurched higher in recent weeks, initially in anticipation of the confrontation, latterly in response to its region-wide impact. Beyond Iran, the world’s largest LNG plant in Qatar has been shut down, as has a key Saudi Arabian oil refinery. The Trump administration has touted US military escorts for tankers through the Strait of Hormuz – the narrow passage of water through which 20% of the world’s energy supply flows – but it is unclear whether this is enough to ameliorate the concerns of the shipping and insurance industries. Brent crude oil has risen from $61 per barrel at the start of the year to $84 at the time of writing, its highest in 19 months. Natural gas prices have risen more sharply, particularly in Europe, where the benchmark is 70% higher year -to-date (though it remains far below the peaks reached in the aftermath of Russia’s invasion of Ukraine).
High energy prices have two significant potential implications. Firstly, they raise the hurdle for economic growth. This is a particular issue for Europe, where high energy prices place the continent’s manufacturers at a competitive disadvantage. Secondly, they raise prices across numerous supply chains and heavily influence consumer’s inflation expectations, which can become self-fulfilling.

Financial markets have initially appeared more focused on the inflationary risks than the consequences for growth. Movements in the markets for nominal and inflation-protected US Treasuries imply that investors are demanding more compensation for the threat of a near-term inflationary spike. Importantly, expectations that the US Federal Reserve may have to postpone widely anticipated interest rate cuts have prevented sovereign bonds from fulfilling their traditional ‘safe haven’ role, with yields rising and prices falling for both shorter and longer dated bonds.

The inflationary threat is ill-timed. Australia – an economy which tends to be among the first to reflect shifts in the global economic cycle – has recently been forced to raise interest rates to dampen reaccelerating inflation. Meanwhile, recent inflation data in Europe, the UK and the US have surprised to the upside. The degree to which events in the Middle East exacerbate these pressures is, to a large extent, dependent on how long the conflict lasts.

Thus far, markets seem relatively confident that, as with previous shocks emanating from the Trump administration, the disruption will prove short-lived – perhaps a couple of weeks, or months at most. We have no insight here. However, it strikes us that the line between confidence and complacency is particularly thin when the range of plausible outcomes is so wide.

We are therefore taking careful note of some intriguing market movements, albeit remaining ever wary of reading too much into short-term volatility. Though a degree of calm has been restored today, European equity markets fell between 3% and 4% on Tuesday before recovering some of the ground lost yesterday: the risks to growth clearly cannot be ignored entirely. Meanwhile gold – often held out as the paragon of inflation proofing – dropped 5% on Tuesday: to quote Howard Marks again (in a different context this time) “there is no investment idea that is so good it can’t be spoiled by too high an entry price”. The risks of the speculative excess that we believe have infected gold have also been on display in South Korea, where the benchmark Kospi index – having previously risen 163% since the end of 2024 – plummeted 20% in two days earlier in the week.

Elsewhere, pressure continues to mount in the private credit market where evidence of inadequate underwriting standards and capital misallocation continues to accrue. Indeed, luminaries such as JPMorgan’s Jamie Dimon have warned of behaviour among lenders that is reminiscent of the build up to the Great Financial Crisis.

We have little to add to the prognostications of journalists, commentators and strategists debating what the future holds for Iran and the Middle East more broadly. We limit ourselves to the somewhat bland observation that, from an economic perspective – setting aside the inevitable humanitarian consequences – the impact on growth and inflation are likely to increase the longer the conflict endures.

However, we argue that the risks currently facing investors are not purely economic. Markets seem confident that, as has been the case with so many dramatic headlines over the past year or so, ‘this too shall pass’. Consequently, we would not be surprised if waves of investors emerge once more to ‘buy the dip’. Nonetheless, for those willing to look, we believe the fraying of the equity bull market is evident in the price dynamics of financial assets that are not easily explained by the risks emanating from Iran. When valuations, expectations and speculative activity are as elevated as they currently appear, it does not take much – certainly not a war – to reveal the scale of the potential downside.

How best should investors respond to this week’s events? This, at least, is an easy question for us to answer: with great caution.

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Heron’s Eye View – Everything, Everywhere, All At Once

Investors keeping a weather eye on financial markets may have sensed a shift in the winds this week. We must be wary of reading too much into short-term market movements – particularly at a time when globally significant headlines seem to appear by the hour. Nonetheless, we believe there is value in understanding the challenges to which the market is reacting and asking whether there might be some common cause. We would highlight six significant developments from the past week alone:

  • Economic Concerns: US GDP grew at an annualised rate of close to 5% in the fourth quarter of 2025. Yet there are signs that all is not well. The latest of these came from two separate data points released this week, both pointing to unexpected weakness in the all-important labour market.
  • Federal Reserve Policy: Kevin Warsh was nominated as the Trump administration’s pick to lead the Fed, once Jerome Powell’s tenure comes to an end in May. Based on past statements, his policy approach is not straightforward. However, the market has interpreted his nomination as reducing the risk that a politicised Fed will debase the dollar and overtly support the relentless expansion of the US government deficit.
  • AI Vs Software: Anthropic, the company behind the Claude chatbot, released a new tool that aims to automate many administrative functions. This led to a sharp sell-off in the shares of companies offering ‘software as a service’ products which could, in theory, be replaced by AI-based solutions.
  • US Tech CapEx: the US tech sector behemoths reported strong earnings growth. However, this was overshadowed by expectations of truly enormous capital expenditures in the quest to ‘win’ the AI arms race. Alphabet, Amazon, Meta and Microsoft will spend an estimated $660bn this year alone – 60% more than last year and $80bn more than their combined operating cash flow. Investors are increasingly questioning the investment returns that can reasonably be expected on these expenditures, wiping c$900bn off the market value of Alphabet, Amazon and Microsoft since they filed their earnings reports.
  • Funding: Jensen Huang made headlines when he cast doubts on the scale of Nvidia’s potential investment in OpenAI. But there are suggestions that funding might also be getting harder to secure away from the spotlight too. For example, an ETF tracking private credit loans sank to levels not seen outside the depths of the pandemic.
  • Speculative Strains: prices of assets that had previously been soaring went into sharp retreat this week. The list of casualties included bitcoin and other crypto tokens, adjacent equities such as Strategy Inc, highly valued AI participants like Palantir, and even real assets such as gold and silver that many consider ‘safe havens’ in times of market stress.

Fig.1: Share Price Performance of Microsoft, Palantir & Strategy Inc, Year-to-Date (Rebased)

Fig.1: Share Price Performance of Microsoft, Palantir & Strategy Inc, Year-to-Date (Rebased)

Investors might be forgiven for thinking the market’s gyrations are simply a one-week whirlwind of unfortunate coincidences. If so, the various challenges could be easily brushed off, and asset prices consequently left free to resume their upward march. Certainly, at the time of writing, it seems investors are happy once again to ‘buy the dip’ in anticipation of a smooth resolution.

In our view, this week’s developments are not mere coincidence. Record government deficits, central bank dependencies amid the financialisation of the economy, the explosion of venture capital and private credit, multitrillion-dollar technology moonshots, sky-high equity valuations, triple-digit returns for supposed ‘safe havens’, the entire crypto industry: all are symptoms of excesses in the financial system.

Individually, each of this week’s developments poses a threat to investors. However, the common underlying cause suggests to us that it is more likely that the apparently disparate vulnerabilities erupt in everything, everywhere, all at once. We firmly believe the only sensible course of action is to position portfolios to protect against the risk of such a damaging scenario. This insurance policy remains valuable unless or until the underlying issue is remedied – even if the symptoms that flared up so conspicuously this week quickly fade from view.

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Investment Update – Irrational Exuberance, Pt.II: What Were You Thinking?

The following quote is a slice of stock market history. It was delivered in a letter to shareholders by the CEO of Sun Microsystems, a US technology firm founded in 1982, in the aftermath of the dot-com bubble.

“At 10x revenues, to give you a ten-year payback, I have to pay you 100% of revenues for ten straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D [research and development] for the next ten years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realise how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”Scott McNealy, CEO of Sun Microsystems
31st March 2002

These words have gone on to serve as a stark illustration of the irrational exuberance that drove stocks to absurdly high valuations in that period. Sun Microsystem’s share price vaulted 965% in the three years to September 2000, fuelled by a 250% rise in profits. Earnings, however, proved unsustainable. Just two years later, the company was loss-making and the share price had cratered 96% from its $259 peak. The company subsequently cycled in and out of profitability before being sold to Oracle in 2010 at just $9.50 per share.

Investors seem to have short memories: today, valuations for a worryingly large proportion of the US stock market rely on similarly fanciful assumptions as those highlighted by Scott McNealy. As shown in the chart overleaf, the proportion of the largest US companies (as measured by their market capitalisation) trading at or above the 10x price-to-sales ratio that McNealy considered “ridiculous” has never been higher. This ought to send a shiver down investors’ spines: it took fifteen years for the tech-heavy Nasdaq index to recover its post-bubble losses.

Fig.1: Weight of Names in the S&P 500 Index Trading at a Price-to-Sales Ratio of 10x or More

Figure1

Source: GQG Partners LLC. GQG provides this information for informational purposes only. GQG has gathered the information in good faith from sources it believes to be reliable, including its own resources and third parties. However, GQG does not represent or warrant that any information and any third-party information provided, is accurate, reliable or complete, and it should not be relied upon as such. GQG has not independently verified any information used or presented that is derived from third parties, which is subject to change.

The common riposte to Scott McNealy’s scathing takedown of his shareholders’ financial literacy – or the lack of it – is that, as CEO, he simply failed to deliver the expected growth that had underpinned Sun Microsystems’ exalted valuation. We hear this same argument touted widely and repeatedly today: an unstoppable AI revolution will power growth for years to come, and what appear high valuations today will eventually be revealed as bargains as the scale of the opportunity is captured in corporate profits. We take issue with this argument. As Howard Marks, the sharp-witted founder of Oaktree Capital Management, likes to emphasise, “there is no investment idea that is so good that it can’t be spoiled by too high an entry price”.

To illustrate our concerns, let us examine some of the candidates that, we believe, could prove to be the Sun Microsystems of 2025. To begin, consider Nvidia, the dominant producer of the GPU computer chips that have powered the AI goldrush thus far. It currently trades at a price-to-sales ratio of 23x (nearly two-and-a-half times Scott McNealy’s “ridiculous” threshold), giving it a market value of $4.4trillion – the highest of any company in the world.

Nvidia is expected to grow its earnings at a mind-boggling 40% per annum for the next five years. If we accept these forecasts and assume Nvidia is able to defend an industry-leading profit margin of 55% over this period, implied revenues five years down the line are $1.1trillion – not far off the total current revenues of Apple, Alphabet, Microsoft and Meta combined. Place a price-to-sales ratio of 2.4x on this – in line with the long-term average for large US companies – and you arrive at a market capitalisation of $2.7trillion, still some 40% below Nvidia’s current level.

Clearly, Nvidia’s unprecedented rate of earnings growth will have to persist for more than five years to justify current valuations. Let’s stetch credibility and assume it delivers 40% growth and a 55% profit margin for another five years1 . At this point, an average price-to-sales ratio would justify a market capitalisation of $14.5trillion, representing a healthy – though not stratospheric – 12.6% annual gain for today’s investors.

The problem is that Nvidia’s annual revenues at this point would surpass $6trillion. We estimate this would amount to roughly one quarter of all the revenues of America’s 500 largest companies, or one seventh of total US GDP in 2035. To put it another way, it would require Nvidia to sell more than $16billion worth of computer chips every day of the year. At current prices, this means selling nearly 250,000 of Nvidia’s highest spec GPUs every day. This daily target is more than ten times the total number that Microsoft’s Loughton data centre – the UK’s largest ‘supercomputer’ – will eventually house by the time of its completion in 2028. We question how – economically and logistically – this can possibly be achieved.

For a second example, let us now turn to OpenAI, the progenitor of ChatGPT. OpenAI’s latest funding round ascribed it a value of $500billion, representing a price-to-sales multiple of some 38x its estimated revenues (nearly four times Scott McNealy’s threshold).

OpenAI is deeply loss-making, with CEO Sam Altman recently declaring that becoming profitable is “not in [his] top ten concerns” – just as well, given OpenAI expects to burn through $115billion of cash by the end of 2029. The firm’s deeply negative cashflow has not prevented it from signing a plethora of deals with a far-reaching network of US tech companies that, in aggregate, commit OpenAI to spending around $1.4trillion in the next seven or so years. Investors should question where Sam Altman hopes to find the money.

True, ChatGPT has enjoyed the fastest growth in users of any consumer-facing application in history and expects to hit one billion users by the end of this year. If it can just make $200 off each of these users in every one of the next seven years, then that $1.4trillion investment might perhaps be affordable. Unfortunately, an estimated 95% of ChatGPT’s users are currently to be found on the free version: the firm has just 35million paying individuals, and 1million business subscribers. With so few subscribers, it needs to make $5,555 from each of them every year to pay for the planned investment. But if it can multiply its subscriber base by a factor of ten, then annual per user revenue of $555 is a much less daunting hurdle.

However, there is a difference between revenue and profit. Even if there are 360million people willing to subscribe to the service2 , growth may not, in fact, be the answer. It is thought that OpenAI currently makes a loss each and every time a paying subscriber runs a query on ChatGPT. Growing the paying user base may increase revenues, but only at the expense of ever larger operating losses.

As challenging as these examples may be, we believe that to consider them in isolation is to miss the bigger picture. To meet its growth targets and justify its current valuation, it seems highly likely that Nvidia needs OpenAI to succeed. If it does so, then perhaps the valuations of Microsoft ($3.6trillion market cap, 12x price-to-sales), Oracle ($592billion market cap, 10x price-to-sales) and AMD ($354billion market cap, 11x price-tosales) among others are supportable – these three are among those entangled in OpenAI’s ambitious network of promised investment. Even still, how profitable can these companies expect to be if they are the source of the astronomical revenues Nvidia needs to generate to justify its status as the world’s most valuable company?

Furthermore, success for OpenAI and Nvidia would surely spell doom for Alphabet ($3.9trillion market cap, 10x price-to sales), Meta ($1.6trillion market cap, 9x price-to-sales) and the many other AI firms hoping to emerge triumphant in a ‘winner takes all’ market.

It is possible that AI proves revolutionary in ways that we currently cannot imagine. However, even in this scenario, it stetches credulity to believe that the growth assumptions underpinning the ambitious valuations of all – or even most – of the participants can simultaneously be fulfilled. To repeat Howard Marks, “there is no investment idea that is so good that it can’t be spoiled by too high a price”.

We strive to keep abreast of developments and to maintain an open mind but, at present, we are not convinced that AI actually is a particularly good investment idea (we will explore this in more detail in our next investment note). However, we are convinced that today’s valuations are more than sufficient to ruin it.

Though the fear of missing out can be uncomfortable, we argue that it pales in comparison to the discomfort felt when unsustainable valuations and growth aspirations eventually collide with reality. As stewards of our clients’ wealth, we consider it paramount to never put you in a position which leads you to ask of us “what were you thinking?” We therefore continue to steer portfolios well clear of the areas of the market where valuations are most precipitous, where the growth forecasts are most demanding, and where the web of interconnected risks is most entangled.

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Heron’s Eye View – Global Equity Market Concentration

Equity markets have become increasingly concentrated in recent years. The implication is that investors in a global equity index are no longer well diversified.

The strong performance of US equities since the Global Financial Crisis in 2008 has pushed valuations towards all-time highs and driven the region’s share of global market capitalisation to record levels. At present, the US accounts for over 72% of global developed equity markets.

The chart below, which shows the evolution of the weighting of US equities as a proportion of global equity market capitalisation, illustrates the trend of rising concentration. The level of US equity exposure now meaningfully surpasses the degree of concentration observed in the dot-com bubble of the late 1990s. Meanwhile, US GDP as a share of global economic output has remained fairly stable at around 25%.

US Equities as % of Global Equities

Within the US equity market itself, concentration is also pronounced. Just ten companies account for almost 40% of market capitalisation, nine of which are technology related. Additionally, JPMorgan calculates that 41 firms tied to the artificial intelligence theme now account for 48% of headline US market indices.

As a result, investors in a global equity index are no longer well diversified. Instead, they are highly exposed to US stocks – and to US technology stocks in particular. Any disappointment in the development or profitability of AI technology could see a large number of index constituents fall sharply and in tandem. In contrast, the equity content of Heronsgate portfolios is well diversified across regions and sectors to mitigate concentration risk.

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Investment Update – Irrational Exuberance, Pt.I: Tech Bubble 2.0

On 5th December 1996, Alan Greenspan, then Chair of the Federal Reserve made a televised speech in which he questioned how central bankers should respond when asset values have been “unduly escalated” by “irrational exuberance” – in other words, by the actions of investors high on optimism but short on analytical rigour. Though he later explained that he had chosen his words carefully, investors were quick to perceive the implicit warning, and US equities fell c5% over the following weeks. However, exuberance soon regained its hold over analysis and the losses were swiftly made good – and then some: excitement over nascent internet and mobile telecoms technology drove a doubling of the market over the subsequent three years, with technology heavy indices up nearly 300%.

Seasoned investors know how this story ended. The US stock market peaked in March 2000, though the bubble only burst decisively in September. By October 2002, broad measures of US equity markets had halved while those more exposed to the technology sector had lost close to 80%. Devout followers of the latter would have had to retain their faith for fifteen years to recoup these losses: seventeen if one accounts for inflation.

Is there a moral to this story? Why did Greenspan issue his warning so far ahead of the bubble’s peak and, having done so, would investors have been wise to heed it? More to the point, why do we think this history is relevant now?

We see a number of parallels between the economic and market environment of the late 1990s and that which currently prevails. In fact, we see so many that this note will aim to do no more than summarise the argument, setting the scene for a series of future notes (identified in the footnotes) in which we will delve deeper into the troubling similarities, explore the differences and attempt to plot an appropriate course of action for rational longterm investors today. In our view, this course demands a cautious approach to the ample speculation evident in today’s financial markets. Happily – as evidenced by the outperformance of short-dated bonds over US equities over the first eight months of this year – watchful investors can still earn reasonable returns as they await the restoration of a more rational market environment.

Parallel Lines

The clearest similarity between the dot-com bubble and now is the excitement over a nascent technology. In the late 1990s, the world was enthralled by potential of the world wide web and affordable mobile telephony. Today, the excitement surrounds artificial intelligence. In both cases, investors identified an epochal change and raced to secure a share of the spoils.

Just like market bubbles before it, the technology driven gold rush of the 1990s triggered a mass misallocation of capital. Investment poured into businesses deemed to be at the cutting edge of the technological revolution and equity market valuations rose to levels never seen before or since. As the euphoria faded, investors were hit with the brutal reality: these companies’ assets were not worth as much as had been thought, they generated very little – if any – profits and, consequently, the wildly optimistic valuations ascribed to them came down to earth with a shuddering thump.

Fast forward to today, and the parallels are clear. Replace ‘the internet’ with ‘artificial intelligence’, swap a few company names, and market commentary from the late 1990s could apply almost seamlessly to today’s breathless headlines. Healthy scepticism is a non-negotiable requirement of a competent investment analyst – it is part of the job to hold the fort against those selling pipe dreams. Our analysis leads us to believe artificial intelligence is unlikely to usher in an era of “extreme abundance” (an extraordinary claim made recently in Forbes magazine) any time soon. Yet, as proved by the dotcom bubble, when the market is expensive, it does not take a failure of the new technology to leave investors nursing huge losses. We note that the US equity market is currently trading at 22.4x next year’s earnings – the closest it has ever come to the record 24.5x registered at the very peak of the tech bubble. The scene is set: anything other than world-changing profitability will see such demanding valuations fall in due course.

In another echo of the late 1990s, we believe the rush to invest in the AI revolution has macroeconomic consequences. We are used to thinking that the economic cycle determines the market cycle: a strong economy allows firms to earn strong profits, which are reflected in rising share prices. However, there are reasons once again to believe the natural order may have flipped. By 2000, rising asset values – working in tandem with the fear of missing out – had seen households all but double their exposure to the stock market. Consequently, the US economy became extremely sensitive to stock market performance. When the bubble finally burst, a recession followed. It is therefore troubling to note that household equity allocations are even higher now than they were 25 years ago (Fig.1). Furthermore, drawing yet another parallel, thanks to the US’ accumulation of huge capital inflows – the consequence, at least in part, of persistent trade deficits – the surge in US equity ownership has not been confined to domestic households, creating the conditions in which a decline in the US stock market could have global ramifications.

Fig.1: US Household & Non-Profit Organisations’ Equity Holdings as a Percentage of Total & Financial Assets

Fig.1: US Household & Non-Profit Organisations’ Equity Holdings as a Percentage of Total & Financial Assets

All these similarities feed one further historical echo, albeit one that is more difficult to precisely pin down. It relates to investor psychology and behaviour – the ‘irrational’ part of Greenspan’s warning. In his history of the 1929 US stock market crash, the economist John Kenneth Galbraith highlights the role that fraud plays in both fuelling a bubble and subsequently bursting it. He introduces readers to ‘the bezzle’ – the accumulation of ill-gotten gains built up over a period of unscrupulous behaviour “when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss”. Distressingly, we see many aspects of the current market which match this description all too well . Such is the scale of today’s bezzle that it seems entirely possible to us that, when today’s victims finally realise their money has been lost, the fall out could rival – or even surpass – that suffered in the wake of the dot-com bubble.

This Time is Different

Those of a more optimistic persuasion will doubtless cast aside Sir John Templeton’s warning about “the four most dangerous words in investing” and claim that ‘this time is different’. Certainly, we have met with a number of strategists who identify the profitability and balance sheets of today’s AI juggernauts as a key contrast to the lack of identifiable revenues associated with some of the dot-com bubble’s headline acts. Today’s technology leaders can afford to invest hundreds of billions in pursuit of the next new thing without racking up huge debts. Equally, investors may point to claims that economic impact of artificial intelligence will dwarf anything that has yet been seen, thereby justifying elevated valuations for the companies involved in its development. Perhaps. We see scant evidence thus far, though we work hard to keep an open mind.

Less open to debate is the stark difference in the fiscal backdrop. By the end of the 1990s, the US had turned its budget deficit into a surplus and was even questioning whether the US government might ever need to issue Treasury debt again. Twenty-five years later, the contrast could scarcely be starker. US federal debt as a proportion of GDP is at levels previously only reached during times of war. Furthermore, bi-partisan projections suggest debt is only going to increase further from here. That the staggering amount of debt has been accrued during a period of generally strong economic growth is historically anomalous, and deeply troubling. It raises many questions : to what extent have tax cuts and government spending supported corporate profitability in recent years, and what happens if they are no longer sustainable? Will international investors remain willing and able to purchase ever more US government debt? And what if the US does tip into recession – will the Federal government be able to finance a recovery package?

Implications for Investors

In our view, the risks currently embedded in the US equity market are substantial. Though we are all too aware of Keynes’ warning that “markets can remain irrational longer than you can remain solvent”, this is not an argument for ignoring warning lights that are flashing ever more insistently. We suspect that we are closer to 1999 than we are to 1996 . Economic momentum is fading, valuations are extreme and the speculative nature of many of today’s most popular ‘investments’ is ever more apparent.

Thankfully, there is no need for investors to risk their solvency: short-dated investment grade corporate bonds offer attractive yields of 5-6% with, we believe, limited risk. Our model portfolios are therefore tilted away from speculative equity markets in favour of the relatively secure – if less exhilarating – prospective returns offered by high quality bonds. Those who read the financial press might not believe it, but each of our recommended short-dated bond funds outperformed the US equity market (in sterling terms) over the first eight months of this year. We are being paid to wait for rationality to return to markets. Though we endeavour to keep an open and honest mind, we are ever more convinced that investors today will be well-served by eschewing speculation, instead adopting a thoughtfully cautious approach to today’s equity market euphoria.

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Heron’s Eye View – What Elevated Equity Valuations Mean for Long Term Investors

Equity markets are currently trading at elevated valuations. The implication for long-term investors is that future returns are likely to be depressed, and risks heightened.

Our previous analysis showed that – across a range of different valuation measures – the US equity market is trading at its highest valuation in over two decades. One of the measures presented was the forward price-to-earnings ratio, which compares the price of the stock market to its expected earnings over the next twelve months. This ratio can be used to demonstrate the relationship between valuations and longterm equity returns.

In the chart below, we plot the forward price-to-earnings ratio of the US equity market at the end of every month since 1985 along the X-axis. For each of these valuation points, we then plot the annualised return generated by the US equity market over the subsequent ten-year period on the Y-axis. The dark blue diagonal line running from top left to bottom right displays, on average, the relationship between valuations at the point of investment and the subsequent returns earned.

US Equity Valuations at Point of Investment and Subsequent 10-Year Returns

US Equity Valuations at Point of Investment and Subsequent 10-Year Returns

The chart highlights the clear historical relationship between starting valuations and subsequent returns: when valuations are low, investors have typically enjoyed strong annualised returns over the subsequent decade; when valuations are high, returns over the next ten years have, without exception, been much lower.

Today, the Forward P/E ratio of the US equity market stands at 22.5x – a level only marginally below that seen during the dotcom bubble of the early 2000s. Historically, valuations in this region (represented in the chart by the vertical grey line) have been followed by long-term returns ranging between +3% and -4% per annum over the subsequent decade. Meanwhile, investors can currently earn relatively secure yields of 5-6% per annum on high quality short-dated bonds.

For those interested in further detail regarding the relationship between valuations and returns, we would recommend reading the latest memo published by Howard Marks, The Calculus of Value.

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Heron’s Eye View – US Equity Valuation Update

Despite a bout of market weakness earlier this year, US equity valuations have remained at historically elevated levels throughout. Such valuations present a significant risk for long-term investors.

In the chart below, we plot the current valuation landscape using five distinct measures: the price-to-earnings, price-to- sales, price-to-book and price-to-cash flow ratios, and also the cyclically adjusted price-to-earnings ratio (CAPE). The first four ratios use consensus analyst forecasts over the next twelve months as the denominator. The CAPE ratio, on the other hand, assesses the current price of the US stock market relative to the average of annual inflation-adjusted earnings over the past decade to smooth out fluctuations in the business cycle. As each valuation ratio has its strengths and weaknesses, we find this combined approach provides a more comprehensive view of the market.

To aid comparison, each measure is compared to its historic range over the past 20 years. A reading of 50% would mean the ratio is in line with its average over this period, while a reading of 99% would imply that, on this measure, US equities have historically only been more expensive 1% of the time.

US Equity Valuation Percentiles

Firstly, it is striking that all measures are currently at, or close to, record high levels (the blue diamonds on the chart). Secondly, even at the depths of April’s tariff-induced turmoil – at which point US equity indices were down some 20% from their peaks – valuations remained extremely elevated (the grey diamonds). Thirdly, we would argue that these ratios are flattered by aggressive consensus analyst estimates. For example, earnings growth over the next twelve months is forecast to be c12%, close to one-and-a-half times the long-term historic average growth rate. Substituting in less ambitious forecasts would leave the market looking even more expensive.

Historically, valuations have provided a strong signal for long- term investors. When the market has been this expensive, future returns have invariably disappointed. Unfortunately, it is also true that valuations offer little insight into short-term returns, and valuation-aware investors must be willing to endure the prospect that the market continues to rise for some time, getting more expensive still. This, however, is not sustainable. While some may argue that “this time is different” because of the historically strong profitability of technology companies that have come to dominate the index, we would counter that high current valuations inescapably reduce the future returns investors can expect from even the strongest of companies – at some point even the most optimistic investor must recognise that prospective returns are more attractive elsewhere.

We would suggest that April’s sell-off shows the risk inherent in the market’s current extreme valuations. If even a 20% decline scarcely moved the dial, what will it take for US equities to return to more reasonable valuations?

Glossary

Price-to-Earnings Ratio: This measures the price of a stock as a multiple of its annual profits. Price-to-Sales Ratio: This measures the price of a stock as a multiple of its annual revenue.

Price-to-Book Ratio: This measures the price of a stock as a multiple of its book value – defined as a company’s assets minus its liabilities – providing a view of its valuation relative to its tangible net-worth.

Price-to-Cash Flow Ratio: This measures the price of a stock as a multiple of its operating cash flow, which is the net-cash generated from a company’s core business activities.

Consensus Analyst Forecast: An average of sell-side analyst expectations for company fundamentals over the next 12-months. These are aggregated to provide a forecast at the stock market level.

 

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Investment Update – Expecting the Exceptional

The US equity market is once again touching all-time highs. Valuations are firmly back among the highest on record, fuelled by expectations that the pace of company earnings growth will be roughly one-and-a-half times the historic average.

The market environment is redolent of clear blue skies ahead: a growing economy, exceptional corporate earnings, inflation back under control without troubling a resilient labour market. It is an appealing vista – but, in our view, a dangerously complacent one. It is not difficult to identify a number of risks, any one of which could derail the equity market’s ascent. In this note we probe some of these risks before turning to valuation metrics, where we find a market continuing to price for perfection.

Risks A-Plenty

  • Growth: US GDP contracted 0.5% in the first quarter, with corporate profits declining and consumption barely growing. True, trade distortions mean a rebound in the headline figure is likely in the second quarter, but this won’t address the weakness in consumption. We note that both the OECD and the Federal Reserve have recently revised down their economic growth projections for the calendar year.
  • Employment: though the unemployment rate has held steady around 4.2% for the past year, there are ominous developments beneath the surface of the US labour market. Increasing numbers of workers are taking part- time work for want of full-time opportunities, the number of companies filing notice of impending job cuts has spiked higher, and those who lose their jobs are finding it increasingly difficult to re-enter the workforce. These are all trends that, historically, have preceded a meaningful rise in unemployment.
  • Consumers: signs of strain are increasingly obvious among US consumers. With the covid-era moratorium on student loan repayments now ended, a record 31% of borrowers – 5.8m people – are classed as delinquent, a marked step up from the pre-pandemic delinquency rate of 12%. Meanwhile, the latest retail sales data showed a sharp slowdown in spending in May, including in restaurants and bars where it is difficult to lay the blame on tariff-related distortions.
  • Trade Wars: tariffs have not gone away. The 90-day pause of Trump’s ‘liberation day’ tariffs expires in early July. A further postponement appears possible. Nonetheless, even the lower levies currently in place on US imports are the highest since the ill-fated Smoot-Hawley act that helped usher in the 1930s depression. Tariffs are expected to raise some $400bn a year for the US government, but this must either be paid for by consumers who are already struggling, or by companies who will see their profit margins decline.
  • Inflation: to the extent that tariffs are passed onto consumers, they are inflationary. This is particularly uncomfortable given signs that, even before their imposition, inflationary pressures were beginning to rekindle. Rent on the median two-bed New York apartment has risen 17.5% year-on-year, Trump’s crackdown on immigration is pushing up prices in areas like agriculture and home care while services inflation remains uncomfortably high.
  • Interest Rates:  the Federal Reserve continues to walk a narrow path between fading growth on one side and stubborn inflation on the other. Though tariffs have not yet made their mark on inflation data, the US central bank recently revised up its projected year-end inflation rate to 3.1%, well beyond its 2.0% target. Against this backdrop, hopes for interest rate cuts can surely only be realised in the event of a material rise in unemployment.
  • Government Deficits: the US Treasury is expected to issue a staggering $1,000,000,000,000 of new debt this year. This comes at a time when investors are already questioning the status of US government debt as ‘the world’s risk- free asset’. It is not only that the Trump administration’s unpredictability merits some sort of risk premium, nor that it appears hostile to overseas investors (who own c30% of the US Treasury market), it is also the risk that the yield on offer is eroded by sustained, high inflation. According to the Financial Times, net outflows from long-dated US bond funds have hit nearly $11bn so far in the second quarter, a meaningful change from average inflows of c$20bn over the past twelve quarters.
  • Debt Sustainability: even the most optimistic forecasts suggest tariff revenues will merely offset those foregone by the tax cuts proposed in Donald Trump’s ‘Big Beautiful Bill’. Tax cuts are aimed squarely at the wealthy who are more likely to save the gains than to spend them. Consequently, the boost to US growth prospects is expected to be relatively muted. This means that concerns over the trajectory and sustainability of US government debt levels are likely to persist.

The economic and political background, then, is anything but benign. From an investor’s perspective, it is not necessary for all of these risks to unfold at once – any one of them is, in our view, sufficient to justify a degree of caution. Yet investors appear largely oblivious, content to keep investing in a market that requires an historically exceptional combination of events to justify further gains.

Where Is The Margin of Safety?

A simple exercise highlights the degree of optimism currently baked into the US equity market. If we assume a certain rate of profit growth over the next twelve months, and then assume investors are willing to pay a certain multiple of those earnings, we can calculate the market level that corresponds to these assumptions. This approach allows us to change our assumptions and explore the potential gains – or losses – at various combinations of earnings growth and valuations (Fig.1).

The green box highlights the current situation: current market pricing reflects expected earnings growth of c13% and a valuation multiple on those earnings of 21.5x.

figure 1

To put the earnings growth expectations into perspective, over the past twenty years corporate earnings have expanded at an annual average of around 8%, so the consensus is expecting the next twelve months to be something like 50% better than average for corporate profitability. Given the risks identified above, this seems a tall order. At the same time, a valuation multiple of 21.5x on these earnings means the market has only ever been more expensive 7% of the time in the past twenty years. In other words, both earnings expectations and valuations are very ambitious.

If it transpires that company earnings growth is, instead, only average – a not unreasonable assumption given the clear slowing of the US economy thus far in 2025 – US equity investors should brace themselves for a loss of around 5%, assuming valuations are unchanged. Of course, investor sentiment might well be dented by disappointing earnings, resulting in lower valuations. If, alongside a return to average earnings growth, the market de-rates to its 10-year average valuation multiple of 18.5x, indices could quickly fall 17% to 20%. If we consider that earnings have fallen c15% on average during recessions we can see that market downside in a malign outcome could be very significant indeed.

But what if our caution over the US economic outlook is misplaced? What if earnings growth comes in closer to double the historic average at 15% and valuations surpass anything seen in the past 20 years, reaching 23.0x? In that case, according to the matrix above, the market ‘should’ be 8% higher. This might appear an attractive prospect but, to our minds, the potential upside is wholly insufficient compensation for the considerable risks involved – especially when compared to the 5% to 6% yields available on high quality short-dated bonds with little interest rate sensitivity and low risk of default.

And what would it take for the US equity market to deliver another year of returns in excess of 20%? Looking at the top right-hand corner of Fig.1 shows it would require earnings growth of 20%, a level only broached historically during post-recession economic recoveries, and a valuation of 24.5x – coincidentally matching the highest ever multiple, reached towards the end of the tech bubble, from which point the market halved.

This exercise reinforces our belief that the risks for US equity investors are tilted firmly to the downside, particularly relative to the attractive yields available on relatively low risk bonds. Why then do US equity market indices continue to march higher day-by-day, almost irrespective of economic and political developments? Our sense is that investors have developed an almost Pavlovian disposition to buy the stock market. A fifteen-year bull market, interrupted only briefly by sharp drawdowns from which losses have quickly been recovered, has conditioned investors to believe the US equity market only ever goes up, and riches are assured as long as one is always willing to ‘buy the dip’.

History tells us that this belief is likely to be misplaced. In our view, the level of the stock market must always and without exception be underpinned by company earnings valued at an appropriate multiple reflective of their growth prospects and attendant risks. As demonstrated above, extraordinary outcomes are required on both earnings growth and multiples if the US market is to continue ratcheting higher. Hence, we are counselling caution and client portfolios are positioned accordingly.

Equity markets will at some point present us with exceptional investment opportunities. However, these opportunities are likely to be found in the mirror image of the current market environment, when investors are more aware of the risks and less entranced by expectations of continued, outsized gains.

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Investment Update – Investing in Extraordinary Times, Part II

The month or so since our last note certainly qualifies as an extraordinary time. With the Trump administration appearing to prioritise tariffs over tax cuts, the prevailing market narrative has been turned on its head; from near universal acceptance of ‘US exceptionalism’ to fears of a sharp economic slowdown or even recession. Such a marked change in the outlook has, unsurprisingly, sent tremors through the previously unassailable US stock market. In this update, we summarise recent market movements and ask whether the worst might now be behind us. Our conclusion?

We suspect not.

At the time of writing, broad measures of the US equity market are between 8% and 12% below their mid-February highs. Dollar weakness has exacerbated the decline, adding another two percentage points or so to the losses suffered by sterling-based investors in US equities. Prominent among the casualties have been a number of the technology titans which had fuelled the market’s phenomenal gains in recent years: Microsoft and Apple are 15% and 17% respectively below their December peaks; Amazon, Alphabet and Meta are down 19%, 20% and 21% from their February highs; even after a 10% rally in recent days, Nvidia is 21% below the all-time high it reached in early January. As troubling as these numbers are for six of the so-called ‘Magnificent 7’, they pale in comparison to those of the seventh.

As CEO Elon Musk embedded himself within Donald Trump’s inner circle, the Tesla share price rocketed from $142 in April last year to a peak of $480 in December. Incredibly, this 238% rise happened even as forecasts for the company’s profitability were being slashed: earnings per share this year and next are now expected to be just half of what was envisaged only twelve months ago (Fig.1).

Fig.1: Tesla Share Price and Forecasts Earnings Per Share for 2025 & 2026

Having defied the downward march of earnings forecasts throughout much of last year, Tesla’s share price finally appears to have responded to the deteriorating outlook. At the time of writing, the share price has halved from its December peak, marking a $750bn decline in the company’s market value. Investors who sat out last year’s meteoric ascent might conclude – perhaps with no little schadenfreude – that this was the inevitable end to a speculative bubble. We suspect, however, there is more to come.

Firstly, despite its recent fall, Tesla stock still trades at an astonishing 82x forward earnings: the share price needs to fall much, much further to bring valuations down to levels at which a valuation aware investor would consider them. Secondly, Tesla faces mounting competition. Importantly, this is not simply a case of cheaper brands becoming increasingly available. Both China’s BYD and Germany’s Mercedes have unveiled technology that dramatically reduces charging times for electric vehicles. At a stroke, Tesla’s battery technology and its global network of 65,000 ‘Supercharger’ stations appears, if not obsolete, then at least far from the impregnable competitive moat many had thought it to be (investors in AI infrastructure, take heed!). This raises serious questions over the company’s growth prospects, yet the share price is merely back to where it was six months ago. Thirdly – and from our perspective perhaps most intriguingly – despite these developments, retail investors continue to buy the stock aggressively. A recent report from JPMorgan highlights that, in the space of just twelve consecutive trading days in March, retail investors bought $7.3bn of Tesla stock, swamping previous record buying streaks. Clearly, a sizeable number of investors continue to believe – or at least to hope – that Elon Musk is a visionary worth backing at any odds.

We find this last point particularly interesting because of the behavioural insights it offers. Are the retail investors buying Tesla shares scrutinising the firm’s future earnings potential, its competitive edge, its (aggressive) accounting practices? Or might it simply be that “buying the dip” has worked so well for so many over the past few years that retail investors are now preconditioned to view any share price weakness as an attractive buying opportunity, whatever the underlying cause? More precariously still, how many of the retail investors buying now at $240 were also buying at $480, and are doubling down, hoping against hope to recover the losses they’ve suffered in the space of three agonising months?

From its staggering valuations to the tribalism provoked by its CEO, Tesla is clearly unusual. However, while perhaps an extreme example, we believe it is instructive for those seeking to make sense of recent events more broadly. In our view, each of the three arguments we applied to Tesla above is echoed at the aggregate market level.

First: valuations. Despite the uncomfortable declines of recent weeks, the US equity market continues to trade at valuations seldom seen before. As measured by the forward price-to-earnings ratio, the market’s valuation was in the 99th percentile of its 20-year range – in other words, it had been cheaper 99% of the time over the past two decades. Now it is merely in the 95th percentile of that range. Other measures of valuation tell a similar story (Fig.2); despite the recent decline, the US stock market remains exceedingly highly valued. A correction that brings it even halfway towards its historic average would entail greater losses than those suffered so far.

Fig.2: Current & Recent Peak US Equity Market Valuation Ratios Relative to the 20-Year Historic Range

Secondly: earnings. The recent equity market shakedown has been driven by an abrupt change in economic expectations. Until recently, investors appeared willing to believe the Trump administration’s agenda was resolutely “pro growth” and that, under his presidency, US exceptionalism would be not just secured but enhanced. In just a few short weeks, however, his prioritisation of tariffs over tax cuts has provoked a truly dramatic decline in consumer and business sentiment, causing the IMF and the Federal Reserve (among many others) to revise down their forecasts for economic growth, while a “nowcasting” model run by the Atlanta arm of the Federal Reserve has swung from projecting annualised growth of 3.9% in the first quarter of this year to an outright contraction of 1.8%. At the same time, the realisation that tariffs are inflationary has raised questions over the extent to which interest rates could be cut in response to any slowdown in growth. Yet in spite of the economic clouds gathering on the horizon, analysts have only inched their forecasts down a fraction and continue to expect robust corporate earnings growth of 11.5% this year and 14.3% in 2026. Should depressed sentiment feed through to weaker consumption and investment, analysts may have to make more significant revisions to their calculations, making questions over heady valuations more pointed still.

Thirdly: investor sentiment. While pouring $3.2bn into Tesla stock during the second week of March, retail investors also added $1.9bn to Nvidia, $1bn to the rest of the Magnificent 7, and $4.2bn to ETFs. Clearly, a large number of retail investors view the recent setback as a buying opportunity. It seems significant that institutional investors do not share this optimism. Indeed, the latest Bank of America Fund Manager Survey revealed the sharpest retreat from US equities on record. Meanwhile, we note with more than a passing interest that Warren Buffett’s Berkshire Hathaway has been disposing of swathes of its US equity holdings and now holds more of its assets in cash and US Treasuries than ever before. Our interpretation is that those with a more analytical approach are drawing back from US equities, leaving those with a stronger behavioural influence to take up the slack and hope for a rebound. Should their hopes prove misplaced, we fear prices may yet have some way to fall.

Are there any reasonable grounds for optimism at all? We must acknowledge that Donald Trump appears to have an exceptional ability to change the prevailing narrative. It is possible that, whether through a new policy initiative or a late-night social media post, he may succeed in rekindling the investor and business confidence that has evaporated so rapidly over the first two months of his presidency. Similarly, with interest rates still at 4½%, the Federal Reserve could feasibly reduce interest rates by a meaningful amount. Meanwhile, the Magnificent 7 may discover a profitable application for AI, answering questions over the returns that can be expected from the colossal investments that have been undertaken.

We believe there are constraints on all three. Firstly, Donald Trump’s campaign pledges of lower taxes, lower deficits and lower inflation remain incompatible: something will have to give. Secondly, the Federal Reserve is walking a narrow path between stalling growth and persistent inflation: it may struggle to cut interest rates even if it wants to. Thirdly, as evidenced by the rapidly increasing number of equally capable AI models, we suspect the benefits will, at least initially, accrue to the users of AI, not to the developers or those that provided the capital. Our view is that downward revisions to AI-related revenues are much more likely than those in the opposite direction.

In summary, these remain extraordinary times. Recent events have offered some encouragement that our analysis is wellfounded, but they do not yet vindicate our long-standing caution towards US equities. However, with valuations yet to fall meaningfully, with earnings forecasts yet to reflect the deteriorating economic outlook, and with retail investors yet to unlearn the habits of the past three years’ bull market, we continue to recommend investors brace for further turbulence ahead.

Volatility should, at some point, present investors with an opportunity to buy equities at attractive valuations and in anticipation of a more positive environment for corporate earnings growth. Recent weeks have inched us fractionally towards this point but, in our view, we remain some way distant yet.

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