January 17, 2025 – On nearly this exact day in 2000, the bubble in dot com stocks reached its frenzied peak. Just one day prior, Federal Reserve Chairman Alan Greenspan cautioned that an observer from the future may conclude that markets were in a speculative bubble. At the time, Greenspan had rightly warned speculators of “irrational exuberance” spreading throughout the stock market. Turns out he was right (although his initial warnings may have been a bit early – the perils of being a bubble-caller).
The phrase, “history doesn’t repeat itself, but it often rhymes” is widely attributed to Mark Twain, but there is no evidence that he said it. Nonetheless, I like the quote not only for its brevity in conveying an important message (learning from past mistakes), but also for heeding a warning that the previously made mistake may happen again, albeit in a slightly different way. It represents a timeless truth about history and patterns in human behaviour, which is highly applicable to investor behaviour specifically. The common Wall Street adage, “The four most dangerous words in finance are it’s different this time”, carries the same message.
Which brings us to current stock market valuations, particularly U.S. large cap growth equities. The valuation of the U.S. large cap growth stocks in the context of global equities is important because, given recent outperformance, U.S. equities are taking a larger and larger piece of the global stock market pie.
It was just one generation ago, during the 1980’s, in which the Japanese stock market was the world’s largest, accounting for nearly half of the global market cap while the U.S. amounted to roughly 30%. That relationship flipped after the Japanese stock bubble burst in 1990 and entered a brutal 35-year bear market, while the technology-led bull market in U.S. equities gained steam that decade. The American market’s share of global equities peaked around 55% as the tech bust and subsequent bull market in emerging markets came to fruition in the 2000s.
However, stock market history and the numerous geographic market bubbles are seemingly irrelevant for the current generation of investors. As the much-loved U.S. equity market has rallied to a new high of 67% of global equity market capitalization, many investors do not heed Mark Twain’s purported, and Alan Greenspan’s confirmed, advice to be wary of historical speculative stock market bubbles and their corresponding irrational exuberance.
Source: JPMorgan
Historical market valuations and their subsequent investment returns are not a rule of thumb, however, the analysis does provide much-needed context in the midst of a near-unstoppable bull market in the S&P 500.
The U.S. market index is currently trading at 22x forecast earnings (a 4.5% earnings yield), compared to its historical average around 15x (a 6.7% earnings yield).
Historically, at the U.S. market’s current valuation of 22x, subsequent 10-year returns for the stock market index have been around 0%, plus or minus 2%.
Source: JPMorgan
That said, there is not much precedent for today’s lofty market valuations. Throughout its history, the S&P 500 has only traded at or above 22x forward earnings between 1999 and 2000 (the data points above cluster around time periods), and the subsequent 10-year returns represented a steep market drop in which investors had negative returns (and much worse for non-U.S. investors, given the depreciation of the USD during that period). While it is difficult to comprehend, I can only imagine how much more difficult it would be to hold onto an asset with a negative return over a decade. Therefore, investors should seek not to repeat past mistakes.
A valuation of 22x earnings or greater is not the only “rhyme” the current U.S. equity market has in common with that of its year 2000 precedent. Twenty five years ago, the tech bubble was characterized by a new era economy, in which an emerging technology (the internet) would revolutionize life as we know it. While the forecast enormous effect of the internet came to fruition, it turned out that the tremendous capital investment into internet infrastructure went overboard. It was a boom turn bust.
The similarities between today’s market environment and that of the tech bubble are two-fold:
1. There is a new era economy, in which a novel technology (artificial intelligence) will revolutionize life as we know it.
2. There is a massive investment into infrastructure to support this new technology (such as AI data centers and Nvidia GPUs).
Below is a thought-provoking chart that provides the bull and bear case for the U.S. equity market’s premium valuation. It all revolves around AI. The bull case indicates that Nvidia’s revenue forecast implies $400 billion of future AI revenue growth from the hyperscalers (a moniker for a group similar to the Magnificent 7 stocks). Conversely, the bear case indicates that the hyperscalers’ projected $400 billion AI revenue shortfall implies an inflated Nvidia revenue forecast along with future declining margins and ROIC for the S&P 500’s largest stocks.
The technology behind AI, large language models (LLMs), is moving at lightning speed. The hyperscalers are investing hundreds of billions of dollars to train and run the most sophisticated LLMs, seeking dominance in AI with top-performing models.
It was the case that the scaling law behind AI indicated that the more one spent on GPUs and power, the better one’s LLM would be. However, this theory may be reaching its limit.
A recently developed LLM from China, DeepSeek V3, is excellent. What is mind-blowing is that the Chinese company created a world-class LLM for just $5.6 million (with an M, not a B) and 2,048 Nvidia H800 chips, which are the Chinese market chips with reduced capabilities. For reference, Meta’s Llama-3.1 was trained for an estimated $500 million. DeepSeek’s industry-leading efficiency makes the hyperscalers’ $100 billion+ of capital expenditures (and related Nvidia revenues) questionable, given declining incremental performance with increased capital spend.
The fact that DeepSeek developed an arguably better-performing LLM than Meta for -99% less capital makes one wonder if AI-related infrastructure spending forecasts may be too bullish.
With an estimated more than 20% of the S&P 500’s valuation dependent on AI data center spending, the commoditization of LLMs, and the resulting drop in AI-related capital expenditures, presents the most significant risk to equity investors in 2025.
If U.S. stocks are overvalued and risky, given elevated earnings multiples and substantial AI-exposure, then perhaps bonds are appealing?
Unfortunately, bonds are no panacea. In October’s memo, “Looking For Yield in All the Right Places”, we discussed why Treasury bonds were unattractive when 10-year yields were around 4%:
“In terms of the wrong places for investors to allocate, bonds are one of the most unappealing instruments in the current market environment. And the reason why bonds are unappealing is that they are overpriced, as yields are far too low. When yields are too low, risks are high, making it more likely that allocators lose money in fixed income… Given current market dynamics, the yields on Government bonds are too low by 150 to 250 bps, implying heightened downside risk for bond investors.”
We also caution allocators on corporate bonds, as credit spreads (the difference between the yield on corporate bonds and risk-free government bonds of the same maturity) have rarely been so low.
Across both investment grade and sub-investment grade/high yield bonds, it appears that investors are not being adequately compensated for the credit risk associated with corporate bond investing, at least compared to historical precedents.
Baseline government bond yields that are too low, combined with credit spreads that are too tight, lead to corporate bonds of consequential duration appearing quite risky and overvalued.
The remaining traditional asset class available for allocators is cash. It appears that investors have been heading the warnings of the valuation risks embedded in stocks and bonds, as the capital allocated to money market funds has surged. Over the past five years, capital invested in American money market funds has doubled to $7 trillion.
Source: Bloomberg
While the mid-4% yields offered by money market funds are a satisfactory place to hide for now, although nothing to write home about, they may lose their appeal as the Federal Reserve continues with its rate cutting program through 2025 and 2026. Once money markets sport a 3-handle (which may be a one-handle after tax), allocators may want to jump ship, seeking higher prospective returns.
With the very high valuation of the U.S. equity market, along with uncertainty around AI-infrastructure capital spending and related revenue growth, risks abound for not only U.S. equity investors but also global investors, given the significant weight of the American market. Managing risk should be at the top of an investor’s playbook in 2025.
What’s an allocator to do?
Diversify.
Diversify equities globally. Diversify asset classes broadly. Allocate to uncorrelated strategies. Mitigate risk. Rinse and repeat.
Accelerate manages five alternative investment solutions, each with a specific mandate:
- Accelerate Arbitrage Fund (TSX: ARB): Merger Arbitrage
- Accelerate Absolute Return Fund (TSX: HDGE): Absolute Return
- Accelerate OneChoice Alternative Portfolio ETF (TSX: ONEC): Multi-strategy
- Accelerate Canadian Long Short Equity Fund (TSX: ATSX): Long Short Equity
- Accelerate Diversified Credit Income Fund (TSX: INCM): Private Credit
ARB gained 0.5% for the month compared to the benchmark S&P Merger Arbitrage Index’s 0.4% gain.
The post-election boom in M&A continues, with twelve news deals announced in the U.S. and four in Canada, worth an aggregate of $42 billion. The Fund added four of these mergers to its portfolio.
Currently, the Fund is 136.3% long and -8.0% short (144.3% gross exposure), with 52% allocated to merger arbitrage (27% to strategic M&A, 25% to leveraged buyouts) and 48% to SPAC arbitrage.
ARB achieved the top returns in merger arbitrage in 2024, outperforming its peers and setting a new standard in the industry.
HDGE had a challenging month in December with a -4.0% decline, bringing the Fund’s 2024 return to 21.8%.
Multifactor performance was negative in the U.S. for the month, with long short value, quality, price momentum, and trend portfolios experiencing negative returns. Historically, during market declines, the factor short portfolios typically underperform the corresponding long portfolios. Unfortunately, this dynamic did not play out last month, and thus the Fund’s short positions were not as effective as expected in mitigating downside participation.
Top gainers for the month include short positions in Couchbase, Chemours, and Flagstar Financial. Top losers include short positions in Maxlinear and SSR Mining, and a long position in Toll Brothers.
ONEC’s diversified alternative allocations mitigated its loss to -1.1% in December as risk assets broadly sold off.
On the positive side of the ledger, private credit was the top contributor to the Fund’s performance, with a 2.2% gain. In addition, the leveraged loan and arbitrage allocations contributed with a 0.6% and 0.5% return, respectively.
The real asset bucket took the brunt of the damage in last month’s sell off, as the Fund’s real estate portfolio declined -5.4% and its infrastructure portfolio fell -3.9%. Some hedge fund strategies struggled, with risk parity dropping by -5.4% and absolute return declining by -4.0%.
While gold fell -1.6% last month, all of the Fund’s other alternative allocations, including Canadian long short equity, managed futures, and commodities, all declined by less than -1.0%.
ATSX returned -0.2% while its benchmark, the S&P/TSX 60, dropped -3.4%. The Fund outperformed its benchmark by 3.2% in December and 0.7% for the year.
In contrast to the performance in the U.S., Canadian long short factor performance generated significant alpha, buoying the Fund’s return in a challenging month for equities.
Top gainers for the month include short positions in Energy Fuels, Nexgen Energy, Interfor. Top losers include short positions in Advantage Energy and SSR Mining, and a long position in Hammond Power Solutions.
INCM gained 2.2% last month, as private credit NAV discounts remained fairly steady and high yields persisted. The current underlying distribution yield in INCM’s portfolio is 11.4%, supportive of high monthly total return performance.
In a challenging December and Q4 for fixed income investors, INCM generated top percentile performance in the fixed income category, according to Morningstar.
Currently, INCM is allocated to 20 private credit strategies, representing more than 4,700 loans and investments, of which 85% are senior secured and 91% are floating rate. The current aggregate NAV discount of INCM’s portfolio is -2.5%.
Have questions about Accelerate’s investment strategies? Click below to book a call with me:
-Julian
Disclaimer: This distribution does not constitute investment, legal or tax advice. Data provided in this distribution should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this distribution is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate Financial Technologies Inc. (“Accelerate”) as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Past performance is not indicative of future results. Visit www.AccelerateShares.com for more information.
