No, we anticipate performance will broaden out beyond mega-cap tech stocks, which have driven US equity performance in recent years. Tech giants are vulnerable to disappointment by the elevated expectations reflected in valuations. Even well-run tech giants that continue to dominate their sectors and maintain high profitability may not deliver strong returns if their stock prices discount too much near-term optimism. Investors should maintain diversified global equity exposure that includes modest overweights to small-cap equities and value equities, which we regard as attractive today.
US equities have already seen significant multiple expansion relative to developed markets (DM) ex US equities, with relative price-earnings (P/E) multiples based on 12-month trailing earnings near all-time highs. Given this valuation gap, we find few scenarios in which US equities would outperform DM ex US equities over the next decade. To sustain outperformance, US equities must both maintain median or higher relative earnings growth and high relative valuation multiples. For context, relative real earnings growth over the last ten years was near median, with DM ex US equities exhibiting stronger earnings growth since May 2021.
Market leadership in US equities was quite narrow over much of last year and is vulnerable to disappoint high expectations. In 2023, top-ten contributors to US equity returns accounted for 64% of the MSCI US Index—the fourth-highest degree of concentration since 1990. Unsurprisingly, the Magnificent Seven—Apple, Microsoft, Nvidia, Amazon, Alphabet, Meta, and Tesla—topped the list for 2023. Such high market concentration has not been positive for markets and is typically followed by sector rotation.
Yet, current market leadership may still have some legs. Research by Empirical Research Partners provides a comparison of fundamental characteristics of today’s ten fast-growing stocks and the broad universe of mid- to large-cap stocks to those of several prior periods that turned into bubbles: the late 1960s go-go mainframe technology and pharmaceutical-led boom; the early 1970s Nifty Fifty boom of large, brand name, defensive “long-term holds;” and the late-1990s technology, media, and telecom (TMT) boom. Relative to past periods of exuberance for mega-cap champions, valuations are lower, and fundamentals range from comparable to stronger than in the past. A distinguishing feature of today’s largest growers is their ability to generate free cash flow. The trailing cash flow margin of the current top growers averages 23%, more than double the 11% average of the three periods at their performance peaks.
The outlook for continued elevated US margins is mixed. The increased globalization, lower corporate taxes, cheaper credit costs, and broad declines in labor’s negotiating power that have powered US margin expansion have largely stalled. At the same time, more restrictive antitrust enforcement has potential to take a meaningful bite out of large US corporate profits, as attitudes about antitrust have started to change. The remaining possible boost in favor of big tech today is cost-reducing technological advances coupled with continued innovation to sustain defensive moats.
Investors will be well served to remember two key lessons. First, tech firms are not impenetrable. What appears to be a barrier to entry may prove temporary, as seen with Microsoft’s former Internet Explorer dominance. Nvidia is believed to have rosy growth prospects, but those could likewise be paired back by competition from another chip giant, like Advanced Micro Devices, who in December announced they were coming out with a 50% faster chip.
Second, even companies with strong prospects can see their stock returns eroded by lofty valuations. If economic growth remains supportive as we expect, the gap between US tech leaders and the rest of the global market will narrow as other market sectors outperform, while these leaders consolidate their gains. Indeed, this transpired for much of the second half of last year. Investors will be well served by remaining diversified with a broad, global allocation to equities, including modest overweights to relatively attractive sectors like small-cap and value stocks.
Celia Dallas, Chief Investment Strategist
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