COLUMN-Dollar turn emboldens dogged wariness of Wall Street: Mike Dolan

By Mike Dolan

LONDON, Aug 26 (Reuters) - So-called value investors have had a brutal decade avoiding what they see as overvalued but outperforming U.S. stocks - and missing the boat. But aside from the handful of high-flying Wall Street megacaps, some insist dollar strength did much of the heavy lifting and the performance of other U.S. firms was not that "exceptional".

We have been here many times in recent years of course - fretting about "over-concentration" of Wall Street's overall performance in a narrow group of stock leaders, only to have underweight funds endure relentless index gains regardless.

Many of them are convinced stellar relative U.S. index gains and valuations are unjustified and unsustainable at historic extremes. But passive index investors care little that the performance is flattered by a few monster tech firms - now almost a third of the S&P 500's .SPX entire market cap.

And, despite last week's brief tech wobble, U.S. benchmarks are again chomping at new records as AI-infused tech giants clock nosebleed valuations more than 30 times forward earnings.

For "value" investors who felt a moment in the sun had come during April's turbulence, the pain just won't go away.

And yet questions about otherwise ordinary business returns from the other 490 odd companies return again and again.

Even though Wall Street indexes are back at record highs they have, unusually, lagged overseas peers all year. The S&P 500's 10% gain to date is less half that of MSCI's all-country index, a third of euro zone stocks in dollar terms and almost a quarter of the dollar-based gains in Germany's DAX index.

The dollar's retreat in 2025 is a key culprit for that underperformance after years of relentless gains. But there's a feeling that if dollar weakness is now one of the unstated goals of President Donald Trump's trade rebalancing and industrial policies, it could end up challenging long-standing assumptions about the "less-than-magnificent" U.S. stocks going forward.

'TREACHEROUS'

Boston-based GMO is one of those leading lights in the value investing world. To its credit, it has long acknowledged publicly how its approach has come up short for far too long.

But instead of throwing in the towel, its asset allocation team's quarterly letter last week reckons the case still stacks up if you exclude the "Magnificent Six" megacaps - their reworking of the red hot tech "Mag7" grouping that's dominated thinking over the past two years with downbeaten Tesla removed.

"Simply flipping one's decision because of a past mistake is a treacherous way to make decisions," wrote GMO's Ben Inker and John Pease. "Investments made on the back of regret turn out poorly more often than not."

The dollar's turnaround forms a key part of their argument.

Inker and Pease acknowledge the fundamental strength behind the "Mag6". However, like many, they question how long the artificial intelligence theme can deliver the same sort of returns for these companies, given changes to their balance sheets that see enormous investment in infrastructure investment, such as data centers.

But the focus of their analysis is on the sources of the broader S&P 500's outperformance versus the rest of the world's stocks over the past 15 years.

Their conclusion was that about 80% of those excess gains against the MSCI World index that excludes U.S. stocks came from returns unlikely to repeat.

FUNDAMENTALS LACKING

While non-valuation sources of return - from organic growth, buybacks and dividends - still did better than overseas peers, GMO points out that most of that outperformance happened before 2015 and was again concentrated in the few megacaps.

From 2019 on, the fundamental outperformance is close to zero, it says. And given that the megacaps continued to do so well, it raises big questions about what was happening with the rest.

The median fundamental return for a stock in the S&P 500 (ex-financials) over the five years ending in December 2024 was an annualized 4.0%, they calculate. That result was lower than for any other five-year increment since the mid-1980s. Over the same period, the median fundamental return for MSCI ex-U.S. was 6.1%.

Three big headwinds lie ahead for most U.S. companies - tariff rises, labor supply problems from an immigration crackdown, and greater policy uncertainty when planning ahead.

These factors coupled with potential dollar losses make a powerful case for investors to rebalance portfolios from pricey U.S. stocks to cheaper overseas ones.

Caveats are that a weaker dollar helps U.S. goods exporters with a local manufacturing base - but GMO points out that's not the description of most S&P 500 firms. Overseas revenues also might improve in dollar terms, but not by as much as investing in overseas companies directly.

"The rest of the S&P 500 ... shares much less in common with the Magnificent Six than most investors seem to think - beyond a lofty valuation premium to the rest of the world," Inker and Pease conclude. "The leap of faith that investors are implicitly making in an acceleration of the aggregate growth of these companies is perhaps touching, but extremely hard to justify."

GMO's dogged tilt away from historically expensive U.S. stocks to better-valued overseas ones is occurring amid a market rotation to more cyclical U.S. stocks - not least on hopes of lower interest rates. That shows faith in staying the course.

Maybe a big test of the GMO strategy rests on the "home bias" of local investors. And yet for foreign funds still heavily invested in the U.S., the question looms large.

The opinions expressed here are those of the author, a columnist for Reuters

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