The US market could be set for a decade of underperformance
The US tech bubble has driven the S&P 500's gains over the past 10 years, and here's why the rest of the world may be about to play catch-up.
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Many Australian investors have started to invest overseas over the past decade. They’ve done it to diversify their holdings and capture some of the better growth opportunities offered elsewhere. For these investors, the US has been a principal area of focus. That’s understandable given America has the world’s largest stock markets, and by some distance.
These investors have been fortunate as the US market has performed extraordinarily well of late, compared to Australia and the rest of the world. The big question is whether this can continue. This article will argue that the odds are against it, and it would be prudent for investors to look elsewhere for performance over the next decade.
US market has trounced the rest of the world
This year, everyone has focused on the performance of the ‘Magnificent Seven’ stocks in the US – Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta. An equal weighted basket of these stocks is up close to 80% year-to-date. And given these stocks are 28% of the S&P 500 index, they’ve been the biggest driver for overall index gains.
It’s not just this year, though. Since 2008, the US has trounced the rest of the world, the latter having gone essentially nowhere.
Breaking the performance down, you can see in the chart below that since 2011, America has soundly beaten all other markets, including Europe (EUR), Japan (JAP), Asia Pacific (APX), Emerging Markets (EM), and Developed Markets (DM).
From this chart, you can also see that the US hasn’t always outperformed the rest of the world. From 1988-2010, it performed similarly to Europe, while Asia and Emerging Markets outperformed the US.
The chart below breaks down the performance in another way. Over the past decade, multiple expansion – increase in the price-to-earnings ratio - has played a big part in US market performance. It’s also worth noting that a decent amount of the earnings growth in the US came from lower corporate tax rates and lower interest costs.
Meanwhile, Emerging Market earnings growth over the past decade has been poor. This can be attributed to the mining boom turning to bust from 2012, US dollar appreciation, and problems in China.
You may also notice the difference to the prior decade from 2002-2012. Then, the S&P 500 multiple proved a significant drag, coming off the tech boom of 2000. Even though earnings growth was robust, US performance was much less so.
Conversely, Emerging Market earnings growth was stellar, earnings multiples were relatively steady, and US dollar depreciation helped. That led to Emerging Markets easily topping the US during this period.
Source: Emerging Market Investor
The US tech bubble
It’s my view that recent US market outperformance has been driven largely by a tech bubble, which seems underappreciated by most investors.
The chart below shows a popular US tech ETF versus the S&P 500. As expected, over the past 10 years, the outperformance has been stunning. Interestingly, over a long period of 25 years, tech has only marginally beaten the market. That puts into context some of the past decade’s tech gains.
Yet as fund manager Horizon Kinetics argues, you need to look beyond performance and valuations to see the extent of the US tech bubble. Yes, the ‘Magnificent 7’ trade on 36x next year’s earnings, and that assumes earnings growth in the high 20s over the next year.
More broadly, though, looking at market weightings for tech gives you a better appreciation of the recent performance. The chart below shows the market value of information technology against the S&P 500. As you can see, it’s closing in on the highs of 2000.
Yet this chart significantly underplays tech’s true weighting in the index. That’s because there are companies that should be part of information technology but aren’t. For instance, Amazon and Telsa are classified as consumer discretionary when they’re arguably not. Amazon’s cloud business generates 107% of operating profits. It may surprise people, but its online retail business is loss making! Netflix, Alphabet, and Meta are classified as a communication companies, when clearly, they shouldn’t be.
If you remove these distortions, the true technology weighting in the S&P 500 is close to 41%, way above the peak of 35% in 2000.
The chart below is the best one I’ve seen showing the extent of the tech bubble.
US markets are arguably expensive
The tech bubble has made the S&P 500 expensive on almost any measure. Warren Buffett’s favourite US market valuation metric, the market capitalization versus GDP ratio, shows that the current market is at 2000 levels, after reaching well above all-time highs in 2021.
The well-known Shiller PE, measuring the current S&P 500 price with average earnings over the past 10 years – shows a price-to-earnings ratio near 30x, well below 2000 levels yet at comparable levels to 1929.
The US also looks stretched compared with the rest of the world. The chart below shows CAPE and PE ratios versus Emerging Markets (CAPE ratios are identical to the Shiller PE mentioned above).
Source: Emerging Market Investor
The arguments for further US outperformance
The pushback against my argument for the US underperforming over the next decade is that America has so much going for it compared to other countries. Things such as:
- Artificial Intelligence
- Cheap, abundant energy
- Innovation and entrepreneurialism
- The world’s reserve currency
- Younger demographics than most of the world
All of this is true, though whether the tailwinds of the past decade are set to last, and how much of that is priced in, are the key issues.
Investing elsewhere – possible problems
If you acknowledge that the US market is stretched, the next issue is where else can people invest internationally. One issue as that much of the world tends to follow US markets.
This chart shows that developed markets are highly correlated with the US at 0.88 (with 1 being perfectly correlated). Even Emerging Markets are reasonably correlated at 0.74.
I’d point out that the Emerging Markets correlation hasn’t always been that high. Otherwise, these markets wouldn’t have been able to handily outperform the US over 10-and-15-year periods before 2012.
The other issue is that large weighting of China in the rest of the world, especially Emerging Markets. China accounts for 28% of Emerging Markets and is therefore a key factor in performance. If you’re bearish on China, it’s hard to be bullish on Emerging Markets as a whole.
Picking your spots
That said, the prospects for some markets remain exciting. For example, Japan is inexpensive and changes to company corporate governance practices are likely to drive higher returns on equity than in the past. Several sophisticated investors including Warren Buffett have bought into this market.
And while Europe gets a bad rap, many companies there are internationally focused and innovative. For instance, Novo Nordisk recently became Europe’s biggest company thanks in part to new obesity drugs which are showing promising results.
The larger point is the US isn’t a one-way bet, and diversifying into other international markets makes sense at this juncture.
James Gruber is an assistant editor at Firstlinks and Morningstar.com.au