JPMorgan Chase’s (US:JPM) chief executive, Jamie Dimon, recently warned that a significant correction in the US stock market could be on the cards within the next six months. This came as a surprise to precisely no one with a vested interest in the market. The top-heavy nature of the S&P 500 is now widely appreciated, as are the fears that the value of artificial intelligence (AI) to the global economy has been overestimated.
But market bulls could make the case that the price/earnings (PE) and cyclically adjusted PE (CAPE) ratios for the leading tech stocks aren’t exactly tottering based on their 10-year averages. Leaving aside Tesla (US:TSLA), the average forward PE for the most prominent US tech companies, including the likes of Broadcom (US:AVGO) and Oracle (US:ORCL), now stands at 29.9 times, hardly bargain basement territory, but not overly extravagant in historical terms.
The clamour (and concerns) over the valuations for AI stocks is best illustrated by the substantial gap between the trailing and forward PE multiples for stocks such as Broadcom and Nvidia (US:NVDA), and the growth assumptions it implies. Prospects for the former company, a semiconductor manufacturer that also makes networking gear to tie Nvidia chips together, are closely intertwined with the development of the wider AI market. Investors have piled in this year, so a yawning gap now exists between the stock’s trailing (83) and forward (36.1) PE multiples. Yet it’s worth noting that since 2009, Broadcom has delivered 11 positive surprises relative to annual earnings expectations – that’s a compelling record.
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In fairness, Dimon wasn’t focused solely on the question of valuations, instead highlighting uncertainties linked to geopolitical tensions, tariffs and worsening fiscal strains; three of the main drivers of the current surge in gold prices.
The question of irrational exuberance towards the tech space is clearly more applicable to the US stock market than it is to its London rival. But given the trend away from ‘home bias’ among DIY investors in the UK, it’s clear that any sell-off would have a material impact on these shores. It has been estimated that overseas equities constitute 42 per cent of total investor fund holdings in the UK, largely driven by investments in the US.
The accompanying chart demonstrates how the rush to AI stocks has widened the gap between growth and value stocks in the US. In the early part of April, the MSCI indices covering US value and growth stocks showed signs of coalescing, but that was a short-run affair. The discount of the former to the latter expanded from 5.4 per cent to 24.1 per cent in the intervening period – worrying given that when this has stretched rapidly in the past, valuations have often corrected in response.
The April market turmoil was triggered by the Trump administration’s “liberation day” tariffs executive order, which raised the prospect of a wave of margin calls against leveraged institutional borrowers. The president has blown hot and cold on the subject ever since, so it’s surprising that markets are still getting periodically spooked by what amounts to brinkmanship for the most part, although the current impasse in relation to China’s rare earths exports could weigh on US indices given their centrality to AI technology.
The chart also indicates that the differential between value and growth stocks in the UK has widened since the second quarter, albeit on an inverse basis to the US. This is to be expected given the relative weightings ascribed to sectors within the S&P and FTSE indices. But critics of the domestic market would claim that it highlights the fact that UK companies are not reinvesting enough earnings in their businesses; the corollary being that priority is given to shareholder returns.
It’s difficult to gauge whether the widening spread between value and growth stocks either side of the Atlantic is justified or otherwise. And there is no reason to assume that we will invariably witness a prolonged downturn in markets even if we’re subject to a marked correction in the short to medium term.
The tech-driven rally in the US commenced in October 2022, which theoretically provides a bit of leeway given that the average bull run lasts about four-and-a-half years. In any event, bear markets invariably present opportunities to buy quality stocks at lower prices for investors with long time horizons. And based on the MSCI figures, a blended mixture of US growth and UK value might just be the order of the day.