By Harry Barr, Investment Manager at Rathbones
Investors frequently ask about current market valuations, particularly for US equities, which dominate global indices, accounting for roughly two-thirds of their weight. The S&P 500 and Nasdaq have delivered exceptional returns in recent years, driven largely by technology-heavy sectors. However, their valuations now appear elevated, resembling levels often seen at market peaks. This prompts critical questions for those managing investment portfolios
The price-earnings (PE) ratio—calculated as share price divided by earnings per share—remains a fundamental tool for assessing equity valuations. It incorporates several components: the risk-free rate (typically the yield on 10-year government bonds), an equity risk premium (the additional return investors demand for the volatility and risk of stocks), and expectations for future growth. Each element introduces uncertainty. What constitutes the “right” bond yield in today’s environment? Historically, the equity risk premium hovered around 3%, but recent compression suggests investors perceive lower downside risks in developed markets. Growth forecasts are equally complex—will a company capitalise on emerging technologies like artificial intelligence (AI), or will it be disrupted by them? Additional factors, such as geopolitical risks or the quality of corporate management, further muddy the waters.
Even with armies of financial experts, predicting returns is tough. A decade ago, a respected global asset manager (unnamed to avoid critique, though data is public) forecast a 6.5% annual return for US equities from 2015 to 2024. The actual outcome was a remarkable 13.1%, nearly doubling expectations. A $100,000 investment, expected to grow to $187,000, instead reached $351,000, showcasing the power of compounding when forecasts miss the mark. The key oversight was underestimating the dominance of leading technology companies, which transformed into oligopolies with powerful network effects—where increased usage amplifies value. These firms generated substantial profits with relatively low capital intensity, which justified higher PE ratios.
This wasn’t obvious at the time. When Apple became the first company to reach a $1 trillion valuation in 2018, many questioned its sustainability. Today, it approaches $4 trillion, and Nvidia has surpassed that milestone, driven by the AI boom. Valuing equities involves blending hard data—like balance sheet strength or cash flow metrics—with subjective judgments, such as a company’s innovation potential or management’s ability to navigate competitive landscapes.
Yet, risks are mounting. The race to develop AI technologies is driving significant capital expenditure, increasingly funded by debt rather than cash flow. This echoes the late 1990s, when overzealous investments in tech led to the dot-com bust. Not all current spending will deliver the expected returns, raising concerns about financial strain or misallocated resources.
From a portfolio perspective, sensible diversification—across individual stocks, sectors, and asset classes—helps mitigate these risks while maintaining exposure to potential market gains. The asset manager mentioned earlier now forecasts 6.7% annual US equity returns for the decade starting in 2025. Whether this proves accurate, one thing is certain: returns will not be smooth. Volatility, driven by economic shifts, technological disruptions, or unforeseen events, is inevitable. Balancing caution with opportunity—ensuring portfolios are positioned to capture upside while protecting against downside—is critical in navigating this complex and unpredictable market landscape.
The value of investments can go down as well as up and you could get back less than you invested. Past performance is not a reliable indicator of future performance. This information should not be taken as financial advice or a recommendation.
