The global stock market looks expensive: what should investors do?

Many investors are overexposed to a relatively small slice of the global equity universe. This, of course, is most glaring in the case of the Magnificent Seven tech stocks, such as Amazon.com Inc (NASDAQ:AMZN), Tesla Inc (NASDAQ:TSLA) and NVIDIA Corp (NASDAQ:NVDA), which account for almost a hefty 30% of the S&P 500 index. This percentage is all the more staggering when you consider that the US itself makes up nearly two-thirds of the global market.

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Matthew Bullock, EMEA head of portfolio construction and strategy at Janus Henderson, points out “the sell-off in 2022 and the concentrated recovery in 2023 helped to highlight for investors just how exposed their portfolios were to US equities, technology and to a small number of tech stocks”.

The US and tech are key drivers for global markets

He adds that many investors will not have intentionally wanted to have their returns focused on such a small number of stocks. He says: “What surprised a number of investors was that this wasn't a deliberate concentration but came as a consequence of their global equity allocations which they had assumed, by definition, would be quite broad. However, we can see by looking at the MSCI ACWI Index just how important the US equity market (63.8%), technology (23.7%) and the Magnificent Seven (circa 18%) are.”

So, for example, an investor who split their savings between the Fundsmith Equity and Rathbone Global Opportunities funds in the belief this would provide exposure to a broad international set of equities might not know that in fact both these funds are even more heavily weighted to the US than a global tracker would be, and are packed with tech stocks including Apple Inc (NASDAQ:AAPL), Microsoft Corp (NASDAQ:MSFT) and Meta Platforms Inc Class A (NASDAQ:META).

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Last year, investing in the Magnificent Seven paid off and these stocks more than doubled in price while the rest of the S&P 500 – around 500 stocks - rose by 12.5%. Today these wonder stocks have an average price-to-earnings (P/E) ratio of over 50x, putting them well into bubble territory.

“At some point mean reversion will kick in,” says Ben Arnold, value investment director, Schroder. “Valuation is gravity for the stock market, although it is always hard to say what the catalyst for value might be.”

Research by Schroders shows other global sectors are looking expensive versus their history, including consumer discretionary, healthcare and industrials.

A separate concern is that investors who have tracked the US market have lost out in the years following periods of high concentration levels. Indeed, according to Schroder research, the higher the index concentration, the better the outperformance of the outlier stocks over the next few years.

How to reduce concentration risk

To avoid bunching in a few giant stocks, you could track an equal-weighed S&P index, where every stock is given a weighting of 0.2% regardless of size. This should outperform when small- and mid-caps, and value investing (rather than growth-style stocks), come back into favour.

Dzmitry Lipski, head of funds research at interactive investor, picks out Invesco S&P 500 Equal Weight ETF Acc (LSE:SPEQ) as one option. He says: “It offers greater exposure to smaller stocks and stocks with lower valuations, providing a better diversified approach to investing in US stocks which could lead to higher returns. By enhancing diversification and reducing concentration at the stock and sector level, the Invesco S&P 500 Equal Weight ETF could be a good alternative to high-fee active US funds that usually struggle to outperform.” 

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There is also a strong case for an allocation to small-caps per se, as they make up just 20% of the global market, but account for 70% of companies. “In a typical 60/40 multi-asset portfolio, having a 9% allocation to small-caps can provide a valuable high alpha diversifier, alongside areas such as emerging market equities,” says Ritu Vohora, capital markets specialist at T. Rowe Price.

For new investors, smaller companies are cheaper than usual, due to this part of the market being out of form over the past couple of years due to rising interest rates. Smaller companies are more domestically focused. In the US, smaller companies provide exposure to the broad economy, and should benefit from its strength, as 80% of revenues are domestic.

The current backdrop is similar to the 1970s with elevated inflation and political uncertainty. While this precipitated a recession, small-caps outperformed for the next decade.

Where investors can find better value opportunities

Investors might also do well to add exposure to undervalued regions such as the UK and Japan, and look at other opportunities in tech space, such as innovation in healthcare, decarbonisation and car manufacturing.

As pointed out by Edward Allen, private client investment director at Tyndall Investment Management, “happily there are plenty of areas of value, and many more fish in the sea”.

He says: “Listing these diversifying undervalued areas in brief: UK and European cyclical companies, Japanese cyclical companies, US mid-small capitalisation companies, biotechnology, frontier markets and some of the emerging markets. The complicating factor is that as soon as you get away from indexed investing there are difficult choices to be made; when will smaller companies start to perform? Is the economic recovery on track? Will the Japanese yen stay weak? To avoid getting caught up in often unanswerable questions, we take the approach that ‘value will out’ and if we allocate capital in a diversified fashion we should capture that value sooner or later.”

UK stands out for bargain hunters

An area Arnold is finding value in is the UK. He points out that it is incredibly cheap relative to history, on a cyclically adjusted price-to-earnings (CAPE) ratio of 8-10x, compared with 28x for the US. The UK remains attractively priced, despite having a strong run of performance since the end of last October.

The UK is also a good diversifier because it is concentrated in very different sectors such as oil & gas, metals, mining, tobacco and construction materials.

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Ian Rees, co-head of multi-manager funds at Premier Miton Investors, notes that since Covid the supply of shares to the UK market has gone into retreat. He explains: “There has been a marked reduction in companies being listed, with the IPO market slowed to a trickle. Meanwhile, listed companies have been busy buying back their own shares because of their healthy cash-flow generation and to take advantage of their depressed prices.

“Unfortunately, the shrinking supply has yet to balance out weak demand. Investors may rightly be concerned that weak prices reflect poor performance, but corporate results do not support this view. Company results continue to be quite healthy, helping them do share buybacks while highlighting their appeal as cheap acquisition targets.”

The International Monetary Fund (IMF) is forecasting UK growth of 1.5% in 2025, which would put it in third position in the G7 league table. However, it is entirely possible the market won’t experience a turnaround any time soon.

An overlooked region and sector

Japan is also cheap, despite its recent strong performance, because inflows have only begun to gather momentum. Ayesha Akbar, multi-asset portfolio manager at Fidelity International, says “valuations have only recently returned to pre-Covid levels, however solid earnings and improving inflation prospects mean these too have room to improve”.

Among sectors, biotech has been particularly overlooked, despite the plummeting cost of gene sequencing in recent years, and the development of new inventions and treatments in gene therapies and personal healthcare.

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Rees notes: “Biotechnology companies are leading this wave of innovation but unlike the growth opportunities of artificial intelligence, it has yet to be reflected in valuations, or create a speculative frenzy. Investors can access this growth opportunity at valuations across the biotech sector that are not far from their cyclical lows.”      

Most asset allocators or fund managers would not advocate that investors should sell out of US stocks or technology. However, when both share prices and valuations rise, it pays to cast the net wider to look for investments that are not enjoying their moment in the sun.

Bullock notes that while “there is still value to be had” for US shares and the technology behemoths, it can pay to go against the crowd.

He says: “What is extremely important in this challenging environment is to look deeper within global markets to find attractively priced opportunities with good growth potential.”