A key feature of market dynamics over the last couple of years (covered in detail in our research output) has been the extreme concentration in the US equity market, most notably expressed as the wide gap between the performance of the headline FT Wilshire 5000 index (distorted by the contribution of the Magnificent Seven stocks) compared to performance of the Equal weighted index.
However, in mid July the release of better-than-expected inflation data triggered a significant rotation with the Equal weighted index and Small Cap stocks outperforming by c 10%. Is this a sign of the Mag 7 trade encountering vertigo?
Exhibit 1: A big reversal in the large cap and Mag 7 trade in July
Increased sensitivity to the widening in the valuation differentials
In Exhibit 2, we compare the prospective 12M PE valuation for the headline index with the valuation for a US ex Mag 7 index. It shows not only a wide difference 21.5x for the former versus 18.1x for the latter, but also a directional difference over the last few weeks with the headline market valuation expanding while the ex-Mag 7 valuation declining.
Exhibit 2: Superior US 2024 EPS forecasts compared with other regions
Creating vertigo with the scale of the PE relative premium
The directional shift in the PE ratio for the aggregate US equity market compared to the ex-Mag7 market shown in Exhibit 2 has pushed the gap (measured by the PE relative shown in Exhibit 3 below) to extreme levels. It is worth bearing in mind that there was valuation parity back in 2016.
Recent rotation could be looking exert some mean reversion into this ratio.
Exhibit 3: Too far, too fast in terms of valuation premiums
Source: Wilshire Indexes and FactSet and Federal Reserve. Data as of July 16, 2024.
