Reiterating investment principles when it comes to U.S. equities

Having posted two consecutive years of 25%+ return in 2023 and 2024, many investors are anxious that U.S. equities could face an imminent correction. Predicting the precise timing of these corrections is impossible, there are some key observations that could help investors to make rational decisions on U.S. equities.

Index highs do not provide reliable signals

First, the absolute level of stock indices does not tell us much about future performance. The S&P 500 index hit its day close all time high 57 times in 2024, and many investors see this as a reason to hold back on investing or take profit. However, our analysis shows that there is little difference in terms of 1-year, 3-year and 5-year return whether investors invested on the day of stock index all time high, or any other days, as shown in Exhibit 1. While index highs can be useful as a reminder to take a closer look at corporate fundamentals to assess whether the market is running ahead of fundamentals, in itself, this is not particularly useful in helping to make decisions on asset allocation.

 Second, there have been extended periods where U.S. equities can generate return for investors. For example, S&P 500 recorded five consecutive years of 20%+ gains starting in 1994 due to an economic soft landing. It also made 3 consecutive years of positive return between 2019 to 2021, despite the COVID-19 pandemic in 2020.

This all comes back to economic and corporate fundamentals. Market rallies don’t end because they have been running for too long. Economic growth and corporate earnings are the key in determining how far a bull market can run.

Elevated stock valuations need active selection

At 21.6 times on a 12-month forward price-to-earnings basis in end-2024, the S&P500 is expensive relative to other markets, as well as against its own history. Much of this is led by the surge in artificial intelligence related technology stocks, and this is much cited as the concentration concern in U.S. equities. We do recognize this concern. While we are confident about the medium- to long-term development of AI (artificial intelligence) and this technology benefiting a broad range of industries, not every company that has invested in AI will emerge as a winner. This would require more in depth stock selection to differentiate.

Meanwhile, the U.S. economic growth cycle remains in good shape and this could benefit from cyclical sector companies, including industrials, materials, financial and consumption. The accumulated gain in these sectors over the past two years have lagged behind technology and hence we see this could be a good way to diversify allocation towards U.S. equities. This is also reflected in the expectation for acceleration in earnings growth forecast for companies in S&P 500 excluding the top 10 companies, as seen in Exhibit 2.

Market corrections are normal

A stopped clock tells the time right twice a day, but it doesn’t mean it’s useful. There are often warnings about imminent market correction and investors should look to embrace such phenomenon instead of trying to time their allocation. As seen in Exhibit 3, on average in the past 20 years, S&P 500 saw an intra-year correction of 14.5%. Even in years where the index has generated positive annual return, the intra-year correction still averaged 11.1%.

Some market corrections are brought by market positioning adjustments, or triggered by short-term data swings or policy changes. More sustained downturns in equites are usually brought by prospects of earnings recession. As discussed above, active selection could help to diversify away from sectors and companies that could be vulnerable to earnings downgrade.

Investment disciplines can help to weather through market volatility

What should investors do? First, they should be clear about the appropriate asset allocation, such as stock-bond ratio, that is needed to meet their investment objectives. Following the last two years of equities outperforming bonds, investors may find their equity allocation could be above what they need, if their portfolio is not rebalanced. Rebalancing their portfolio to the desirable allocation proportion implies that they would naturally take profit on outperformers. On the other hand, if there is a correction in the market in the future, further rebalancing would allow investors to add back stocks at a more reasonable valuation.

To deploy cash, investors may opt to add their allocation to U.S. equities in several batches. In a market that we expect to see positive return in the medium term, this dollar cost averaging methods can help investors to take advantage of any potential correction and improve the overall cost of investment.

Given the concentrated performance of U.S. equities in the past two years, active selection should be key to tap under appreciated opportunities, as well as mitigate risks. As mentioned above, not all AI developers will be successful and hence it will be key to identify the potential winners. This is not limited to the tech sector, but other industries who could implement AI solutions effectively.