Here's Why the U.S Stock Market Dominated the Last 12 Years
And why that dominance is unlikely to continue over the next decade
Even investors who agree it’s important to diversify their portfolio often fail to diversify by geography–which means investing in assets outside of your home country.
U.S investors are more likely to invest all their money in the U.S, just as U.K investors are more likely to invest all their money in the U.K. Wherever you live, you likely have a bias towards investing all your money within that country. This home country bias is especially understandable for U.S investors.
From 2010-2020 the U.S stock market outperformed international stocks by 8% per year. With that level of dominance for such a sustained period, U.S investors–especially those who started investing during this period–could be forgiven for thinking that all you need to do to diversify a portfolio of stocks is buy an S&P 500 index fund.
Except there is no reason to believe that outperformance will continue.
Historically, the performance of U.S vs. international stocks has been a pendulum; in one-decade international stocks have outperformed, and in another, U.S stocks have outperformed.
In this article, I review the key points from a very useful research paper from Vanguard titled “A tale of two decades for U.S. and non-U.S. equity: Past is rarely prologue”.
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Context: The decade of U.S outperformance followed “the lost decade”
To hammer home the idea that the U.S is not an inherently better or safer investment than international stocks, consider the context for the exceptional returns for U.S stocks in the 2010s.
These returns came on the heels of the “lost decade,” where the S&P 500 entered 2010 at roughly the same level it began in the year 2000.
The 2000s were a rough ride for U.S investors.
The dot com bubble popped.
September 11th happened.
The financial crisis led to the worst recession since the great depression.
During the 2000s, international stocks outperformed U.S stocks. Then in the 2010s, U.S stocks came roaring back. What will happen in the 2020s? I don’t know, Vanguard doesn’t know, and I can assure you the stock market gurus on Twitter and CNBC have no idea either.
All we can do as rational investors is look at the evidence and weigh the probabilities.
Here’s the evidence Vanguard put forward in its December 2020 paper for a comeback in international stocks in the 2020s.
68% of U.S outperformance was due to expanding multiples
The first place to start is asking ourselves what factors contributed to the outperformance of U.S stocks in the 2010s?
The largest factor was rising valuations for U.S companies compared to non-U.S companies.
Rising valuations mean that investors have to pay more for every dollar of profit a business generates. It’s critical to remember that by investing in stocks, you are not buying a piece of paper. You are buying partial ownership in a real-life business.
The initial valuation when you buy a stock significantly impacts your expected return as an investor. All else being equal, buying at historically high valuations implies lower expected returns and vice versa.
Remember that U.S stocks outperformed non-U.S stocks by 8% per year during the 2010s. 5.4% or 68% of that outperformance was attributed to the expanding valuations forcing investors to pay more for a dollar of earnings for U.S stocks.
If the valuations of U.S stocks don’t continue to rise in the 2020s, there is very little reason to believe the level of U.S outperformance will continue. If U.S valuations contract, there is good reason to believe international stocks will outperform U.S stocks going forward.
The dominance of the U.S dollar relative to other currencies accounted for 27% of the outperformance of U.S stocks relative to international in the 2010s.
After the great financial crisis, the U.S economy rebounded faster and stronger relative to most other countries. This led to a demand for U.S dollars and an increase in the value of the dollar.
A rising dollar means that assets held in other currencies are worth less than an asset held in U.S dollars.
If the dollar continues to rise, that will contribute to a possible scenario of continued U.S outperformance. If the dollar weakens, that would contribute to international stocks outperforming U.S stocks.
The uncertain nature of these factors is a case for international diversification
Vanguard’s estimate for annual stock returns in the 2020s:
U.S — 4.7%
International — 8.1%
They believe that the majority of international outperformance will be due to a closing gap in valuations between the U.S and international stocks and a slightly weaker dollar.
Of course, that’s just one estimate, and nobody knows what will happen. We can also be confident that this estimate will be wrong.
I’m reminded of the quote from British statistician George E. P. Box. who said:
“All models are wrong, but some are useful.”
Projections like the one made by Vanguard are probably wrong.
However, it’s useful because it reminds us that the rational investor buys a portfolio of U.S and international stocks, putting themselves in a position to capture the gains in the stock market no matter where in the world they came from.
Want more tips on rational investing? Check out these articles.
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This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.