Is the US market due a correction?

Over the last couple of weeks, some market watchers have become worried about US equity valuations and concerns about a potential market correction have gathered pace – by Garry White

 
Equity markets dipped in August this year as concerns about a potential US recession spread through global markets. These concerns proved overbaked – there was nothing in data released prior to the market wobble that suggested the world’s largest economy was slipping towards contraction. Subsequent data backed up this view and the equity market rally continued, fuelled by excitement surrounding prospects for artificial intelligence (AI) and the new products derived from the technology.

Recent worries have not been fuelled by fears of a recession across the Atlantic. Concerns centre around elevated equity valuations on Wall Street and the potential for a market correction. Now the mighty Vanguard, the largest provider of mutual funds and the second-largest provider of exchange-traded funds (ETFs) in the world after BlackRock’s iShares, has joined the valuation worriers. Vanguard economist Joe Davis compared the current market with that seen in the dot-com boom in 1997, noting that valuations increased the risk of a stock price “pullback”.

Once again, exuberance about the future returns offered by new technology is responsible for driving markets higher. The rise of the internet led to the dot-com boom and subsequent crash at the end of the last century, this time the technology causing the effusive over-optimism is AI, according to Mr Davis. He thinks the market has overestimated the short-term potential of AI technology, but noted it was difficult to determine the timing of any pullback – even if it will happen in 2025.
 

Could AI boom become a bust?

 
Shares related to AI have become the main driving force behind the rise of the US stock market, with the S&P 500 index up more than 28% this year, with about one-fifth of this increase coming from the contribution of AI chip manufacturer Nvidia. The wider “magnificent seven” group of technology giants has been responsible for more than 50% of the S&P 500’s returns. Other technology giants have also benefited immensely from betting on AI, with privately held OpenAI’s valuation reaching an astonishing $157bn based on funding rounds.

“We see roughly 60-to-65% odds that AI is more impactful than the personal computer. The US stock market today is pricing roughly a 90% probability,” Mr Davis noted.

For many investors, the US market has become the only game in town when it comes to investing in equities. It is where the companies leading the digital revolution are based and where the future of the world is being shaped as technology comes to dominate every aspect of our lives. Earlier this week, Financial Times columnist Ruchir Sharma argued that this US-centric mentality prevalent in international investors was inflating a bubble and damaging fundamentals in other economies around the world.

“United by faith in the strength of US financial markets and their capacity to keep outperforming all other economies, global investors are committing more capital to a single country than ever before in modern history,” Mr Sharma wrote.

This attitude can also be seen in the leading global market index – the MSCI World Index, which tracks the largest companies around the world. US equities now make up 70% of the index, more than double the 30% level seen in the 1980s. This index is supposed to be a benchmark that reflects the state of the global economy. Instead, an investment in the MSCI World Index is really an investment in the major Western technology companies.
 

Is a correction likely?

 
So, are US equities over-owned, overvalued and overhyped, as Mr Sharma pithily observed? Is the US stock market in a bubble that is about to go ‘pop’?

Well, clearly the valuation of the US equity market is pretty rich. The S&P 500 is trading at a forward price-earnings ratio of 22 rimes, which is elevated by historical standards and higher than when Donald Trump first took office in 2017. Current consensus forecasts predict a 14% increase in US corporate earnings in 2025, outpacing most other regions in terms of growth, return on equity, and net debt levels.

The election of Mr Trump for a second term as president has sparked optimism among investors who foresee a business-friendly environment conducive to growth and innovation in the coming years. Interest rates are also heading lower, albeit slowly. However, risks remain, particularly from tariffs and trade tensions with China, which could affect specific sectors. Nonetheless, any resulting reflation may enhance earnings and mitigate concerns about high corporate valuations.

However, valuation levels mean that earnings growth will need to be the primary driver of price increases moving forward. Any potential correction could be healthy.

When equity indices rise steadily for an extended period, a market correction can be viewed as a healthy pullback before the market index continues its uptrend. These market corrections can help readjust the valuation of asset prices that have become unsustainably high. Market corrections tend to be short-lived, with the average market correction lasting about four months.

Concerns about the valuation of the US market are likely to continue into next year. It means that earnings reports will become extremely important in determining the direction of individual companies and the market as a whole. Earnings misses are likely to be punished hard. But if Donald Trump cuts regulation and taxes and these costs savings flow down to the bottom line of corporate America, they should help support valuations at these levels. It’s also in the hands of Big Tech as to whether they can monetise new developments in AI in the short term – and start generating tangible profits that demonstrate the optimism surround AI has not been overhyped.
 
Garry White is Chief Investment Commentator at wealth manager Charles Stanley