US equities continued to outperform in 2023, with a 26% total return that exceeded non-US developed market equities at 19%, emerging markets at 10%, and Chinese equities, which lost 11%. Such strong performance has pushed US equity valuations into their top historical decile, meaning US stocks have been cheaper at least 90% of the time.
The Wealth Management Investment Strategy Group (ISG) acknowledges that US stocks are expensive, both on an absolute basis and relative to non-US equities. In fact, US markets are more expensive than equities in almost any other country or region (India is the one exception).
Even so, ISG continues to recommend that clients maintain a long-term strategic overweight to US equities in their 2024 Outlook report, America Powers On. They also recommend clients maintain their allocations in US equities rather than tactically shifting into bonds, cash, or non-US equities. ISG’s forecasts may differ from those of other groups at Goldman Sachs.
Stay invested in US equities relative to non-US equities
“We do not advise underweighting US stocks and allocating proceeds to developed or emerging market equities,” write Sharmin Mossavar-Rahmani, chief investment officer of Wealth Management and head of ISG, and co-author Brett Nelson, ISG’s head of tactical asset allocation.
For one thing, US equities aren’t as expensive as they first appear relative to their non-US counterparts. The mix of sectors in these markets varies significantly, and this affects the market’s overall valuation. Some sectors are more expensive, such as technology, so an equity market index with a heavy technology weighting will have a higher valuation.
For example, the S&P 500 is weighted toward expensive technology shares, which trade at a price-to-earnings ratio of 27 times expected earnings for the next 12 months. It has smaller weights, relative to non-US markets, in financial stocks at 15 times earnings and the energy sector at 11 times. The composition of earnings also differs among country indexes. Technology stocks represent 29% of US index earnings but just 1% of earnings in the UK equity market. (Technology shares include the information technology, interactive media and services, and broadline retail sectors). In contrast, energy stocks constitute 20% of earnings in the UK equity market but a smaller 7% share in the US.
If one adjusts the sector weightings of the UK, eurozone, Japanese, or emerging market equity benchmarks to be similar to those of the S&P 500, the valuation gap narrows significantly. For example, the valuation premium of the US to the UK market drops to 23% from 82% after making these sector adjustments. While non-US markets still trade at a discount even after these modifications, these discounts aren’t large enough to overcome the higher risks in these markets, in ISG’s view.
Another reason to stay invested in US stocks is that valuation differentials haven’t historically been a useful signal of countries’ future relative performance. The valuation discount of non-US developed market equities to US equities has been widening for decades, as measured by the MSCI EAFE Index and the S&P 500. “The relative cheapness, however, has had no impact on the performance of EAFE equities relative to that of US equities in the subsequent year,” according to the report. The conclusion is similar for EM equities.
What else favors US stocks over non-US stocks? The authors point out that US earnings per share grow faster. EPS for US stocks have more than doubled since their peak in 2007 just prior to the Great Financial Crisis. Over the same period, EPS of the rest of the world increased 22%, and eurozone earnings rose just 4%. ISG expects US companies to continue generating persistent, faster, and more diverse growth in earnings relative to their non-US competitors.
Other advantages for the US economy and equity markets cited in the Outlook include:
Relatively less dependence on China as a destination for exports or a source of corporate revenues. This may be desirable given the prospect of slowing growth there.
Growth impact of generative artificial intelligence. Goldman Sachs Research estimates that the boost to growth that may come from generative AI will be felt first, and more strongly, in the US.
Safe-haven status. Even with its own domestic political tensions and divisions, the US may benefit as investors seek safe assets during a period of elevated geopolitical risk.
The report is quick to caution that that US equities won’t always outperform other markets, certainly not as significantly as they have in the years since the GFC, when they have beaten non-US developed markets by 9 percentage points annualized. Indeed, ISG expects non-US equities to outperform US equities by about 2 percentage points in 2024. But since these returns are stated in local currency terms, if the dollar appreciates by ISG’s expected 2% this year, US and non-US developed equities would actually have similar returns.
Nor does ISG expect US equities to deliver the same high absolute returns in the next few years as they did in 2023. “Similarly elevated valuations in past periods have weighed on equity performance over the subsequent five years and lowered the odds of positive returns,” the report notes.
Stay invested in US equities relative to bonds or cash
ISG also doesn’t recommend clients lock in some of their gains by selling their US equities and allocating the proceeds to bonds or cash.
This is because ISG’s expected returns for US stocks over the next one to five years are marginally higher than the expected returns for bonds and cash. In addition, for taxable investors, the decline in US stocks that’s needed to offset the tax consequences of selling US equities with significant capital gains is very high.
More broadly, ISG believes the hurdle to underweight US equities is high given the strong upward trend in earnings that have lifted US stocks over time. In the absence of an imminent recession or large disruption that has not already been priced by the market, ISG’s general investment philosophy is to stay invested in US.
Disclaimer: The Investment Strategy Group, part of the Asset & Wealth Management business (“AWM”) of GS, focuses on asset allocation strategy formation and market analysis for GS Wealth Management. Any information that references ISG, represents the views of ISG, is not financial research and is not a product of GS Global Investment Research and may vary significantly from views expressed by individual portfolio management teams within AWM, or other groups at GS.
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