By Julian Cane, manager of the CT UK Capital & Income trust
There is a very clear link in many investors’ minds between a domestic economy and the success or failure of that country’s local stockmarket. Surely, if the economy grows, the stockmarket will flourish?
The clearest evidence in favour of this is the unparalleled growth of the US economy and stockmarket over more than the last century.
It is certainly difficult to argue that a weaker economy would be good for the local stockmarket, but there are reasons to believe that the performance of stockmarkets, and certainly many individual companies, can be unrelated to their domestic economies.
Domestic listing, overseas revenues
Whilst companies are listed domestically, many will earn substantial amounts of revenue overseas – and this is particularly true of the UK stockmarket.
Of the total revenue generated by FTSE All-Share companies, only a quarter (25.6%) comes from the UK.
This is almost exactly the same as the amount of revenue generated by those UK-listed companies in North America (25.4%). So, for the UK stockmarket index, revenues generated in North America are as important as revenues generated in the UK, and international revenue is almost three times more important than domestic revenue. Emphatically, the UK stockmarket is in no way a proxy for the UK economy.
Even for the 25% of revenue generated in the UK, comparisons with the domestic economy are fraught. Some 45% of UK domestic GDP is spent by the public sector, where productivity is notoriously poor.
For the most part, companies will be selling to the private sector, which historically has experienced growth greater than the state sector.
Valuations
There is plenty of anecdotal evidence that some investors and asset allocators have lost confidence in the UK economy and have been throwing in the towel on UK stocks.
Over the past few years, investors have piled into the ‘magnificent seven’ US tech stocks, and while there has been a recent market correction fuelled by tariff announcement made by President Trump’s and the emergence of DeepSeek, valuations in the US still far outweigh those in our domestic market.
If it is wrong to base asset allocation decisions on the headline prospects of a domestic economy, what should investors look at? For stockmarkets as a whole, valuation is the clearest predictor of future investment performance.
It is empirically rare for expensively valued markets to produce strong returns. There are several reasons for this, but most obviously high valuations imply that investors are already well aware of, and perhaps fully invested in, the market.
Yes, markets are driven in the long-term by fundamentals such as earnings, cashflow and dividends, but in the shorter-term more speculative investor flows often dominate share prices.
If companies and markets fail to live up to over-hyped expectations, their over-blown share prices can stagnate or even fall precipitously. Related to this is the recognition that trees don’t grow to the sky and a combination of factors – including competition, obsolescence, poor management, regulation – will almost inevitably cause company share prices and index performance to be disappointing at some stage.
The real-life illustration of why valuations matter is the recent performance of the FTSE All Share relative to the main US stockmarket indices. Over the past 12 months, the FTSE All-Share index performed more strongly than the magnificent seven US tech stocks, the more broadly based S&P 500 and the Nasdaq.
In simple terms, a year ago UK stocks were valued too cheaply, and US ones too expensively, and this valuation difference has worked through into performance.
The valuation gap is still very much there with the UK stockmarket valued cheaply at present both in comparison to its own historic valuation ranges and relative to international peers.
The FTSE All Share was recently trading at around 13 times prospective earnings, while by contrast the S&P 500 was trading at more than 24 times.
Market concentration
Concentration risk within both UK and US indices is a real and growing issue. Historically, conventional thinking would suggest that mainstream indices are a low-risk way to invest, but the dominance of a small number of the very largest companies in the weighting of these indices really should cause investors to think again.
At the start of the year, the magnificent seven made up one-third of the S&P 500 index (relegating most of the other 493 stocks almost to irrelevance), while the largest four companies in the FTSE All Share now make up 25% of the index.