Time to Break Up with the US Stock Market? Why We Say No

The 2I Shock: High Inflation and Interest Rates

Over the years, the US stock market has endured a variety of shocks, but the most recent one delivered a one-two punch. First came a dramatic surge in inflation, and it was followed by an aggressive response by the Fed. In June 2022, US inflation peaked at 9%, its highest rate in 40 years, then ended the year at 6.5%. The Fed then hiked interest rates by a record-breaking five percentage points within a year (Exhibit 1). We call this combined impact of high inflation and rapidly rising interest rates the 2I shock.

Exhibit 1

The 2I shock led the Fed to cut the money supply beginning in October 2022—for the first time in more than 50 years. The S&P 500 entered bear territory in October of that year, with its value down by 19% by end of 2022 versus the year before. In addition, US GDP contracted in the first two quarters of 2022. It bounced back in the second half of the year, but real GDP growth of only 1.3% in the first quarter of 2023 was taken as a possible sign of an impending slowdown. Consumer spending remains sluggish in 2023. The indications of a growth deceleration that initiated in the third quarter of 2022 are anticipated to culminate this year, with GDP growth forecast at a mere 0.2%.[1]

The US Market—Still a Financial Behemoth

Not surprisingly, the 2I shock generated headlines inside the United States and globally. Some of the most dramatic messages hinted that investors might be motivated to move their focus to other geographic markets. Headlines in such widely read sources as Bloomberg, the Wall Street Journal, and Wealth Professional referred to investors “seeking shelter in emerging markets,” “hunting for gains in foreign stocks, ”and “seeking bargains” in international stocks.

We consider such messages to be exaggerating the potential of the alternative markets and understating the role of US markets. The US stock market thrives, boasting a colossal $43 trillion in market cap—roughly eight times larger than the next-largest developed market(Japan) and more than six times larger than China’s market. Furthermore, the US market has the largest share of publicly traded stocks available to public investors—an 81% average float (Exhibit 2). Indeed, US listed firms generate total revenues more than twice those of China and have the highest operational efficiency at companies with sizable revenues. Further, the multiples of US firms have been resilient, matching leading economies’ metrics and have made significant gains. Together, these measures show sustained investor confidence.

Exhibit 2

The Rise and Stall of the Eight Biggest Companies

Within the US stock market, the experience differs according to company size. Based on companies’ market cap, we segmented the US equities market into three broad groups (Exhibit 3). We found that the US markets’ outstanding performance was primarily a result of the substantial contributions of the Almost-Trillion Cohort (ATC)—eight companies with market caps exceeding $500 billion.[1] With the cost of capital around zero, the ATC were able to attract investor funds so they could make bold moves to accelerate growth and improve profitability.

Exhibit 3

What followed was a virtuous cycle favoring these eight ATC companies. Investors valued their revenue growth and rewarded them with high multiples, attracting more investors and notable gains. Their combined enterprise-value-to-sales multiple, which started at a market-leading 2.4, rose 2.5 times to reach 6.0. In contrast, for the market as a whole, EV/sales rose 1.5 times, from 1.8 to 2.7. The pattern was especially notable in the tech sector.

The climate that favored the ATC changed in 2022 as the Fed began raising interest rates. We have now entered a period of yield curve inversion, and short-term T-bills—those with maturities less than two years—are yielding 5% or more. With risk-free assets yielding premiums like those for risky assets, the risky bets placed by the investors in the large companies and tech sector suffered a downfall. Over the ten years ending in 2022, the eight ATC companies achieved remarkable growth in total shareholder returns (TSR): 21.2%, which surpassed the S&P 500’s 14.0%. However, TSR growth for 2021–22 was −25.5%, worse than for the S&P 500, which averaged−12.3% (Exhibit 4). As a result, the eight companies lost substantial enterprise value, and their multiples shrank; the tech sector followed a similar pattern.

Exhibit 4

In 2023, inflation (excluding energy) continues to be above the Fed’s 2% target, so the market expects that the Fed will continue to raise or at least maintain interest rates at 5% or higher. If this expectation becomes reality, investors will have no reward for taking risks in the next decade; so, they are likely to seek lower-risk vehicles.[1]

Sub-$5B Industrial Companies: A Low-Risk, High-Return Alternative

The conditions that pressured the largest companies in 2022 do not necessarily mean the most resilient companies lie outside the US markets. Investors have many promising companies to choose from among the small to midsize market-cap companies in the US market. The largest number of publicly traded companies valued at $1 million or more are within the industrials sector (see Table 1). Among the 729 companies valued at $5 billion to $500 billion, more than one-third are industrials, and in the sub–$5 billion category, close to one-fourth of the 1,248 companies are industrials.

Table 1
US Companies by Industry and Market Cap

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Overall, the sub–$5 billion market capitalization industrial companies make a strong case for being a viable alternative for investors in the coming decade, based on how these companies combine their low-risk profile with potential for higher returns.

Markers of Low Risk

We see three markers of low risk at sub–$5billion industrial companies:

• Across-the-board operational performance. Collectively, sub–$5 billion industrial companies (the industrial S5C) have displayed a remarkable track record of sustained growth over the past decade, with a notable 3.5% increase in revenue, surpassing the overall revenue growth rate for companies of similar size within the United States. And on EBITDA margin expansion, the industrial S5C consistently outperform their counterparts in the same size category.
• Strong balance sheets. With an average debt to equity of less than 1, the industrial S5C currently maintain an ideal leverage position. Additionally, their average current ratio, which measures current assets against current liabilities, stands at 1.7, eclipsing the 1.5 for companies of similar size across other sectors in the US. Notably, these companies hold sufficient cash reserves to cover 40% of their short-term liabilities. These strong fundamentals on their balance sheets afford these companies a significant margin for error and the potential for resilient recovery in challenging times.
• Attractive industry structure. The industrial sector enjoys favorable structural attributes, desirable conduct of its participants, and fragmentation in both its supplier and customer base. The technological landscape of the industrial S5C appears stable, in contrast to the relentless tech “treadmill” witnessed in sectors with considerably higher R&D investments, such as the technology sector. The sector’s multifaceted focus, given its 13 distinct segments and nearly 60 micro-verticals, results in a live-and-let-live ethos and fosters favorable competitor dynamics. Finally, the sector’s fragmented customer and supplier base amplifies the sector’s resilience and adaptability.

A Foundation for High Returns

Three factors together lay the foundation for higher returns for the sector:

•  Learnings from Trailblazers. The industrials S5C can draw valuable insights from a select group of 78 companies we’ve identified as “Trailblazers.” These companies not only exhibit a current EV-to-sales ratio exceeding 50% of the sector’s overall average but also have successfully enhanced this metric by at least 1.25 times over a decade. We associate the Trailblazers’ achievements with their use of a set of proven strategies: active portfolio management, balance sheet and liquidity management, stellar operating performance, and constructive engagement with investors.
• Lower valuations at present. With average multiples (EV to sales) nearly 0.5 times lower than those observed in the broader US market, the industrial S5C now finds itself in an undervalued position. Further, while the industrial S5C has consistently outperformed the financials S5C in terms of operational metrics in the past decade, their valuation multiples are only half those of the financials S5C. Thus, there is significant potential for growth in the valuation of industrial S5C, especially if they choose to embrace the playbook employed by the Trailblazers.
• Secular trends. Significant policy changes, exemplified by the Infrastructure Investment and Jobs Act (IIJA) and the CHIPS and Science Act, underscore the industrial sector’s national significance, with $70 billion in direct funding allocated by the 117th Congress. Furthermore, a shift toward sustainability, including the adoption of EVs, electrified tools, and eco-friendly packaging, is gaining momentum. Supply chain disruptions since 2020 have spurred reshoring, supply base diversification, and digitization. Finally, pivotal technological advancements like additive manufacturing, industrial IoT, and AI-driven processes are amplifying the sector's growth prospects.

With a low-risk and higher-returns profile, sub–$5 billion industrials have arrived at their time to shine. The Trailblazers, with their formidable valuations trajectory, have already demonstrated that they are a viable alternative investment for investors in the 2I environment. Other companies in the sector can follow suit by adopting the playbook of Trailblazers: focus on active portfolio management, balance sheet and liquidity management, and operating performance and play the game with investors. On the investor side, those who get to know the players in this sector have a chance to participate in its areas of low risk and high potential returns.

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