Perspective

Is this end for US stock market dominance?


David Brett

David Brett

Investment Writer

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For more than a decade the US stock market has been the stand out performer.

US stocks have risen by 13% per year since the global financial crisis, according to the MSCI USA Index. That compares with 6% outside the US, using the global equities ex-US Index data.

It has persisted throughout the outbreak of Covid-19 this year, which has led to questions about how much longer US stock market dominance can last.

We spoke to Sean Markowicz, an analyst in the Research and Analytics team, and Stuart Podmore, a behavioural finance expert. They explained why US stocks have been so dominant, what might end their run and what investors might consider in the future.

What are the reasons for the US stocks out-performance?

Sean Markowicz: “The main reason US equities have done so well is because they have generated superior profit growth.

“For example, from 2009 to 2014, again using the MSCI Index data, US earnings-per-share – a company’s profits as a percentage of its share price - grew at 17% per year, compared with only 7% outside the US.

“US firms have not only experienced faster profit growth, but they have also been able to reinvest those profits at increasingly higher reinvestment rates.

“Since 2008, US firms have been able to increase their return on equity (the profitability of a business as share of its stock market equity) by 25%, relative to their global peers.

“Those two forces have really been the driving components of their superior stock market out-performance.”

Why has profit growth in the US has been stronger than elsewhere in the world?

Sean Markowicz: “A number of long-term forces have been supporting that trend.

“Globalisation has made it possible for many US firms to export to new markets, as well as reap the benefits of cheap labour in places such as China.

“The tax and borrowing environment has been very favourable for corporates over the past few decades too. US tax rates have come down significantly, especially after the recent Trump tax cuts.

“A lot of US corporates have taken advantage of this by exploiting these tax arbitrage opportunities.

“Global equities are also able to reap some of these benefits, but US firms have been the key beneficiary.

Which sectors have performed best?

Sean Markowicz: “The defining feature of the previous decade has been the shift towards industries that show long-term growth potential, namely information technology.

“Since the financial crisis, economic growth has been relatively scarce, it's been quite an upward battle to return to the pre-crisis norm.

“Investors have placed a premium on faster-growing stocks, the likes of Apple, Amazon and Google.

“The problem is that the rest of the world has relatively little exposure to this fast-growing field. They are predominantly made up of more traditional cyclical business, like car manufacturers and energy companies. As a result, that's held back their performance.”

How difficult has it been for investors to ignore the success of US stocks?

Stuart Podmore: “Very. I think in behavioural finance terms we can very clearly see some herding at work.

“Our brains work very much as comparison machines, so people will be investing and comparing that to what other people do.

“That is very often one of the reasons why a herd or momentum is created. Investors are probably making that comparison without even realising.

“That leads to the development of that herd in the marketplace and for people to believe or extrapolate that that will forever continue.

“In behavioural terms, once they have acquired some of those US stocks, we are back to the idea of endowment effects. People will often demand far more to give up those assets than they would be willing to pay to acquire them.

“With over a decade of holding those stocks, people are going to be quite reluctant to relinquish them.

“Also, in uncertain economic times, we look to strong leaders to absorb some of that risk and make some of those decisions for us.

“What is going on here is that investors are also looking to the US and thinking that it's still perceived as that leading and dependable market with the energy and the dynamism to bounce back."

What might stand in the way of continued US stocks dominance?

Sean Markowicz: “Although the US has been the best performer this decade, it was one of the weakest performers in the previous decade. Investors often forget that performance leadership tends to be cyclical.

“For example, it outperformed for 12 years in the 1990s until the US tech bubble burst. Then we had increased globalisation and the industrialisation of China, which paved the way for a boom in emerging market equities.

“We saw a similar story in the seventies and eighties when Japan led the world through its asset market bubble and its seemingly infallible economic model.

“The point is that there have always been winners and losers, and these can fluctuate over time.”

“If we bring that back to where we are now, most of the US outperformance has moved in tandem with relative earnings expectations.

“For every increase in US earnings relative to the rest of the world, that's been reflected in share prices.

“However, what's happened now is that the gap between relative returns and earnings expectations has widened.

“It suggests investors are willing to pay a premium for US equities, even though the analysts' forecast for earnings no longer support that.

“In other words, US share prices have a lot of optimism baked into them.”

Stuart Podmore: “Some of that optimism might be driven by the idea of anchoring and adjustment errors.

“For example, you might begin the process of estimating an appropriate price to earnings ratio (PE) on a privately-held company by identifying an anchor.

“You might look at the average PE of public companies in the similar or same industry, and then you adjust that PE estimate upwards or downwards, according to the private company's growth prospects.

“In psychological terms there are now might be anchoring and adjustment errors, and people are extrapolating the present situation or circumstances and believing that that will continue.”

How expensive have US stocks become?

Sean Markowicz: “The price you pay, which you can measure through various stock market valuations, is often used by investors as a guide to future returns.

“At the moment, valuations would suggest that things don't bode so well for US equities. They have  stretched to levels which would have historically foreshadowed low returns for US equities versus the rest of the world.

“The most widely used valuation metric is what's known as the cyclically-adjusted historical earnings ratio, so CAPE. It divides a stock price by the company's average profits over the past 10 years. A low number represents better value.

“On this measure, US share prices currently trade at 25 times their cyclically-adjusted earnings, that compares to the only 13 times for global equities. So, the outlook for the US, relative to other markets, no longer seems as attractive as it was 10 years ago.” 

Are there any areas of the market that concern you?

Sean Markowicz: “The big tech names look vulnerable. The likes of Amazon, Apple, Google, Facebook and Microsoft, these firms amount to 20% of the US equity market. They have accounted for a third of US equity returns over the past five years.

“Often when big companies rise quickly and their market matures, they might fall asleep at the wheel in innovation or regulation hinders their growth. As a result, their stock price suffers.

“There was a study by Research Affiliates, which found that once a company achieved the top position by market capitalisation, it tended to underperform its country benchmark over the subsequent 10 years. And so as they put it, the company becomes too big to succeed.

“This isn't to say they won't remain industry leaders in their respective fields. You can look at IBM, General Electric, they're still strong dominant firms in their industries.

“The point is that these firms may no longer become the motorboat for equity returns going forward. That could weigh on the dominance of US equities relative to the rest of the world.”

If US dominance does falter, where might investors look?

Sean Markowicz: “One area investors might want to pay attention to is the more economically sensitive part of the global equity market.

“For example, the cyclical stocks represent around 58% of the MCI All Country World ex-US Index, but they only amount of 36% in the US equity market.

“The reason that difference is important is because cyclical stocks tend to perform best after the economic cycle bottoms. There are reasons to believe we could be in that stage right now.

Are there any reasons why US stock leadership might continue?

Sean Markowicz: “The main thing that investors need to stay on-guard regarding is whether earnings expectations catch up to the share prices

“An uptick in US earnings, whether it be through some stimulus package in the US, tax rates coming down further, or some other tailwind, that could certainly help them.

“At the same time, margins would need to continue to expand. They have increased by an immense rate since the financial crisis.

“Probably most importantly, the tech companies that have led the world will need to continue to dominate without any significant regulatory backlash.

“That said, the bar is set very high. We can never really claim to know in foresight, the way we do in hindsight, why and how these leadership cycles may shift.

“But what we do know is that conditions are ripe for reversal. That's not to say it will happen. We don't know when it might happen, but I think from a purely risk management point of view, investors may be wise to at least look beyond US borders for the decade to come."