This Time It’s Different

These famous last words have been used in various contexts. In financial circles, whenever a new and trendy investment opportunity emerges, valuations often go out the window, and people proclaim these words. However, the truth remains that the price you pay for an asset always matters. Looking at the current environment, the AI craze is at the forefront. Will AI revolutionize our lives? Will it replace entire industries? The reality likely lies somewhere in between, with AI augmenting our lives. However, our focus here is not on AI but on the topic of valuation and asset bubbles over time.

Source: Apollo Management (November 5, 2023)

In the chart spanning four decades above, we can observe various asset bubbles. Identifying bubbles while you’re in them is a challenging task. It’s equally impossible to predict the next bubble—when it will start, continue, or end. Nevertheless, by using history as a guide, we can note that when certain stocks are trading at over 50 times forward earnings (some even exceeding 100), valuations are stretched. Historically, stocks have traded in the 14-18 range, depending on prevailing interest rates. In higher interest rate environments, valuations tend to be lower. Therefore, when we encounter valuations of 50, 75, or even 100 times, caution is warranted. In fact, on October 10, 2023, the Bank of England, a major central bank, issued a caution “valuations for some financial assets, particularly US Tech Stocks, may be too high.”

So, what should we do? To avoid sounding repetitive, diversification remains key. While having exposure to AI and high-flying assets is important, we must also ensure that our portfolios include a range of other investments.

Are other segments of the market expensive? Let’s investigate. Within the US, examining the S&P 500 reveals that seven stocks have gained 50%, while the rest of the S&P 500 has remained flat for the year. Out of the remaining 493 stocks, 50% are negative for the year. Underweighting assets that have already performed well and incorporating the other 493 stocks into our portfolios makes financial sense. This approach aligns with the essence of value investing, which we advocate.

Source: Apollo Management (September 2023)

Additionally, small and mid-size equities appear to be attractive compared to their larger counterparts. The chart below illustrates forward earnings ratios (PE Ratio) of the US Small Cap Index, indicating that small company stocks (small-cap) are reasonably valued compared to large company stocks (large-cap). The last time we witnessed such favorable valuations was during the tech bubble in 2000; otherwise, they haven’t been this inexpensive since the late 1970s.

Source: BofAML Global Research as of April 2023

Over the past few years, we’ve also emphasized that international equities are undervalued in comparison to US markets. Cycles exist where the US outperforms international markets, and vice versa. The chart below illustrates these cycles over the last 25 years, with the current trend being one of the longest periods of US outperformance. Many professional investors believe it’s time for this trend to reverse.

Source: AMG as of June 30, 2023

This chart doesn’t reflect that, outside of the 6-7 large tech stocks, international stocks have actually outperformed US stocks in recent years. Moreover, the extreme concentration of returns in the US is not as prominent in international markets, making international investments particularly attractive for value-oriented investors.

Charts and graphs are valuable tools for understanding various valuation differences and supporting a diversified approach, as well as a value-based approach where overweighting lower valuation stocks is sensible in this environment. However, the most basic advice we’ve all heard is “don’t put your eggs in one basket,” and diversification is the ideal strategy to follow this age-old advice.

As always, feel free to reach out to your Bluerock Team with any questions. Remember, the only bad question is the one left unasked.