One Way To Manage Small-Cap Valuation Risk

A common refrain we hear across all different types of investors is this: “U.S. equity markets are becoming expensive.”

The fact is that U.S. equity returns have been strong for an extended period, and many market analysts are thinking that they won’t be able to continue their strong run indefinitely.

What Contributed to the U.S. Rally We’ve Witnessed?

If we take a step back and assess some of the factors contributing to the strong U.S. equity run, we may be able to locate those—or at least similar—conditions beginning to show themselves in other markets. These markets could be ripe for a similar run, potentially in the future, at least if history is any guide.

Low Interest Rates & Easy Monetary Policy for an Extended Period: The U.S. Federal Reserve (Fed) has only just begun to normalize the size of its balance sheet and raise the Fed Funds policy interest rate. Since the global financial crisis of 2008–09, there has been nearly a full decade of easy monetary conditions in the U.S., and though we don’t believe that is the sole determinant of higher equity markets, it was certainly an important factor.

Recent Reduction in Regulations: Among the Trump administration’s policy priorities is the reduction in regulations to make it easier for firms to do business. It’s possible that less regulatory restriction could help allow productivity to rise off the very low levels we’ve seen of late. That may have the potential to extend the U.S. equity rally that has been intact for almost 10 years.

Massive Innovation in Technology Firms: Hardly a day that goes by that at least one of the following “F-A-N-G” (Facebook-Amazon-Netflix-Google) companies isn’t mentioned. These companies have shaken up how many things—for instance, buying Thanksgiving dinner—are done. While the performance of these companies has been incredibly strong, it is very difficult to say that these firms are in a bubble akin to what we saw at other companies in the 1999–2000 period, which we now know of as the “tech bubble.”