Investors often fall into this trap of extrapolating past performance into the future because they have trouble imagining a future that is different from the present. But if history is any guide, outperformance does not last forever, and US equities could soon suffer this same fate. In this paper, we examine what factors could sway performance in favor of international equities.

US Earnings Advantage Has Disappeared

Looking back over the past decade, the main reason US equities have done so well is because of their profit growth.  For example, from 2009 to 2014, US earnings-per-share (EPS)⁴ grew at 17% per year compared with only 7% outside the US (FIGURE 1). Part of this can be attributed to the stronger US economic recovery after the GFC, as Europe was still reeling from its sovereign debt-crisis, while a collapse in commodity prices put an end to the EM growth rally.

At a corporate level, the US is also home to some of the most successful companies in the world, including firms such as Amazon, Apple, and Google, which have delivered significant profit growth and technological innovation. US companies have also engaged in more shareholder-friendly activities such as share buybacks, which have boosted EPS growth (by reducing the number of shares in issue, buybacks raise the level of EPS growth for a given level of aggregate earnings growth).

The problem is that this earnings growth advantage has pretty much disappeared. From 2015 on, nearly all of the relative outperformance was driven by a combination of valuation multiple expansion (i.e., higher P/E ratios)⁵ and dollar strength. This mirrors the pattern observed in the 1990s shortly before the US stopped outperforming. Of course, valuations can always climb higher, but not indefinitely.

Peak-Profit Margins?

One justification for this valuation premium is that US firms have been able to reinvest their profits at increasingly higher reinvestment rates. For example, since 2008, US public companies have increased their return on equity (ROE)⁶ by 64% relative to their international peers. ROE can be decomposed into the product of net profit margins, leverage, and asset turnover. FIGURE 2 shows how these component parts have varied for US equities compared to international equities. Since 2008, improving profitability and leverage have both been tailwinds for the US. In fact, research shows that US equity prices would have been 40% lower if not for the secular expansion of profit margins.⁷

However, the structural forces behind these drivers are now under threat. For instance, although globalization has offered companies access to new export markets as well as cheap labor in places such as China, trade frictions and the disruption to supply chains brought about by the pandemic have increased the incentives for onshore production, which could eventually weigh down on US margins.

The Price You Pay Matters for Returns

Although valuations have a poor track record of predicting short-term returns, they have far greater power as a guide to long-term prospects. Historically, the cyclically-adjusted price-to-earnings ratio (CAPE)8 has had a correlation of -0.83 with subsequent relative 10-year US returns (a high US CAPE relative to an international CAPE has preceded low returns for US equities relative to international equities, and vice-versa) and explains 68% of its variation over time.

For example, back in December 2007, US equities had a CAPE ratio of 22x, compared with 27x for international equities. Since the US market was relatively cheaper, it was poised to outperform over the subsequent decade. Today, however, US equities trade at a multiple of 33x earnings versus 18x for international equities. Betting that US equities could continue to outperform over the next decade no longer looks like a winning trade.

Admittedly, the composition of the US market has evolved somewhat over time, with an increased weighting to capital-light businesses, and this may warrant a higher valuation compared to before. This brings us to the next issue: the dominance of technology firms.

Too Big to Fail?

Investors often reassure themselves that “this time is different” and on certain fronts, the FAMAGs—Facebook, Amazon, Microsoft, Apple, and Google—certainly stand out as impressive businesses. Historically, they have rapidly grown their profits, commanded large market shares, and continued to innovate to stay ahead of their competition. The pandemic has accelerated these trends by making us more dependent on their services.

However, these companies have become so large that they are essentially driving the market. In 2020, the S&P 500 Index9 climbed 18%, and the FAMAG stocks—just five companies out of 500—contributed 9% (half of the Index’s total return). Their combined market-cap weight has more than doubled from about 8% of the S&P 500 Index in 2015 to 23% today (FIGURE 5). This means the largest US stocks now account for a larger slice of the market than at the peak of the dotcom bubble in 1999.

The largest US stocks now account for a larger slice of the market than at the peak of the dotcom bubble in 1999.

International Equities Offer Cheap Exposure to a Cyclical Recovery

An important similarity between the current environment and previous market cycles is the composition of the US equity market. As of 12/31/20, cyclical stocks represented only 39% of the S&P 500 Index while non-cyclicals represented 61%. This mirrors the experience in the early 2000s, as shown in FIGURE 6. By comparison, cyclicals today represent 55% of the MSCI All Country World ex USA Index while non-cyclicals represent only 42%. Typically, cyclicals have generated strong performance after the economic cycle bottoms, so a lower relative weighting in this segment could limit the rebound in US equities once global growth recovers, which is inevitable at some point. For example, despite a recovery in cyclical indicators in the early 2000s, tech stocks continued to pull back from their lofty valuations, effectively dampening the overall market performance. This same scenario could play out again. 

Conclusion

US equities have benefitted from several tailwinds relative to international equities over the past decade: profit growth, rising leverage, improving profitability, world-beating companies, and investors being more prepared to pay ever-higher prices to invest in them. However, we believe it would be unwise to bet that these will all continue unchecked. While timing an inflection point is very difficult, all signs tell us that gravity will eventually bring these “rockstar” large-cap equities back down to earth.

US share prices now bake in earnings growth that is at odds with analyst expectations—and analysts are not exactly known for their pessimism. Valuations have been stretched to levels that would have historically foreshadowed low returns for US stocks versus the rest of the world. Meanwhile, we believe politicians and regulators are unlikely to allow large US technology companies to wield ever-greater power. And compositional differences indicate that international equities could outperform in a cyclical upswing. A tilt toward international equities may also prove beneficial if the dollar weakens.

Let’s also not forget that winners, both within markets and between markets, vary considerably over time. The last decade has belonged to the US, but history shows that performance leadership is cyclical. Therefore, we think it would be prudent for equity investors to consider diversifying their equity exposure across international markets.

To learn more, talk to your financial professional about your allocation to international equities.

¹ Earning growth differentials refers to US companies whose profits are growing at the same pace as foreign companies. 

² MSCI USA Index is a free float-adjusted market capitalization index that is designed to measure the performance of the large and mid cap segments of the US market.

³ MSCI ACWI ex USA Index is a broad-based, unmanaged, market capitalization weighted, total return index that measures the performance of both developed and emerging stock markets, excluding the US.

⁴ Earnings Per Share is the projected growth rate in earnings per share for the next five years.

⁵ Price/Earnings (P/E) is the ratio of a stock’s price to its earnings per share.

⁶ Return on Equity is the average amount of net income returned as a percentage of shareholder’s equity over the past five years.

⁷ “Peak-Profit Margins? A US Perspective.” Bridgewater, February 2019

⁸ The CAPE ratio is a valuation measure that uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle.

⁹ S&P 500 Index is a market capitalization-weighted price index composed of 500 widely held common stocks.

Appendix: We compute the market cap weighted implied and forecast growth for the MSCI USA index and the MSCI AC World ex US Index. We compute the spread between these measures as the MSCI USA Index minus the MSCI AC World ex US Index. We trim the growth metrics at 5th and 95th percentile to reduce the impact of outliers. We extract the implied growth from the Residual Income Valuation Model – this is the short-term growth rate which if applied to consensus earnings forecasts results in the current valuation. The key assumptions in this model are the cost of capital which is the measure we use to discount future earnings back to present value and the time periods over which we expect a company’s growth rate and profitability will deviate from the market. 3 Year Forecast Annualized Growth is the growth rate over the next 3 years based on IBES Consensus Estimates.

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Important Risks: Investing involves risk, including the possible loss of principal. • Foreign investments may be more volatile and less liquid than US investments and are subject to the risk of currency fluctuations and adverse political and economic developments. These risks may be greater for investments in emerging markets. Diversification does not ensure a profit or protect against a loss.

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