For most of the past decade, the U.S. stock market was the only game in the world worth playing. While shares in Canada and other countries struggled to generate modest returns, U.S. companies – especially the biggest ones – generated results that left competitors in the dust.
A handful of all-American giants – think Apple Inc., Microsoft Corp., Amazon.com Inc. and Alphabet Inc., for starters – now dominate vast swaths of the digitized global economy. Many investors have come to think of their pre-eminence as a fact of life.
But people with hefty U.S. exposures in their portfolios should think again, according to Ben Inker, head of the asset allocation team at GMO LLC, the widely followed Boston-based money manager. In his most recent quarterly note, published Tuesday, he mounts a strong argument in favour of diversifying outside the United States.
Investors should pay attention. There are a growing number of reasons to be wary of what lies ahead for Wall Street.
On Tuesday, the Institute for Supply Management published figures showing the U.S. manufacturing sector has contracted for the first time in three years. The downbeat news suggests U.S. President Donald Trump’s trade war with China is coming home to roost and adds to other bearish indicators. Most worrisome is the recent inversion of the bond market’s yield curve. Similar inversions have preceded every U.S. recession over the past half century.
It’s possible the current clouds will blow over if Washington and Beijing defy the odds and manage to strike a trade deal, but Mr. Inker, a noted bear, argues the outlook for U.S. stocks appears dim even if you take a positive view on what lies ahead for the largest American companies.
“Even giving [these businesses] the full benefit of doubt on their future profitability would still leave them looking expensive versus the rest of the world,” he writes.
He points out that corporate profits in the United States have historically shown a strong tendency to fall back to average – to revert to the mean, in the jargon. From the 1930s onward, corporate profits would go up and down as a slice of the overall economy, but always come back to a level around 6 per cent of gross domestic product.
Then, starting around 2004, something happened. Corporate profits climbed and didn’t fall back. Over the past 15 years, they averaged around 9 per cent of economic output, well above historical norms.
It isn’t clear exactly what drove the profit surge, but one clue comes from which businesses are enjoying the most benefit. By and large, the biggest profit gains for U.S. companies have been concentrated among the largest firms – many of them in the technology sector. The top 50 companies enjoyed percentage gains in profitability between 2006 and 2019 that were more than double the level of profit increases among smaller companies.
“The top 50 companies really started to distance themselves from the pack by the late 1990s and today have opened a huge gap on the rest of the listed universe,” Mr. Inker says. “Smaller companies, by contrast, have seen little or no change over the period, which leaves the large majority of public corporations in the U.S. enjoying no benefit from the greatest advance in overall corporate profitability in U.S. history.”
The lopsided distribution of gains has put a damper on business investment, he argues. The biggest U.S. companies are wallowing in cash, but since many already enjoy effective monopolies and dominate their sectors, they have little room to expand their existing businesses. In contrast, smaller companies are struggling to increase profits and often don’t see the case for expanding in the face of stiff competition.
So what happens now? Mr. Inker says he believes reversion to the mean is still the most likely outcome, especially given the growing desire of regulators and politicians to rein in the tech giants. If corporate profits fall back to their historical norms, U.S. stocks will be hard hit.
Even if profit margins stay where they are, U.S. stocks still look like a bad deal because of their lofty valuations. Assuming no change in profitability, the S&P 500 index of large U.S. stocks is likely to produce after-inflation returns of only about 1.1 per cent a year over the next seven years, Mr. Inker calculates. By comparison, international stocks are primed to generate 3.1 per cent annual real returns and emerging markets, 8.2 per cent.
“My guess is that the world in the future will be less favourable to these large, dominant companies than is true of the current environment,” Mr. Inker says. Even in a world where profit margins revert to the mean only slowly, he asserts that U.S. stocks look “meaningfully worse than the other groups of equities we forecast.”