By Tim Courtney, Chief Investment Officer
It’s no secret that American stocks have been outpacing their European counterparts. While U.S. large cap markets are wrapping up some of the highest 5 and 10 year returns ever (16% and 13% annualized respectively), international markets over the last 5 and 10 years have produced mediocre returns of 8% and 6% annually.1 This divergence is stark considering that over longer time periods the returns of European/international and U.S. markets have been very similar.
Since the inception of several international indexes in 1970 through 2007, the S&P 500 returned 11% annually compared to 12% for the MSCI Europe and EAFE Indexes.1 Returns began favoring the U.S. following the 2008 global financial crisis. It is normal for returns to diverge and helpful for diversification purposes. In fact, the U.S. and international markets have taken turns as the outperforming market multiple times over the last 55 years. But the magnitude of the divergence since 2008 is unprecedented.
One reason for this is that the fallout from the Great Financial Crisis hit international markets and profits much more forcefully than it did in the U.S. International indexes have higher weights to banks and financials than indexes in the U.S.2 Post crisis, the U.S. has been able to lean on other sectors to drive returns, like tech and communications. European markets have lower weights to these profitable sectors and did not easily pivot.3 Another major reason for the divergence has been the strength of the U.S dollar, which is up 34% against other currencies since 2007.4
These two forces though – U.S. earnings superiority and dollar strength – have greatly weakened since the pandemic. From April 2020 until now earnings growth in Europe has equaled earnings growth in the U.S., and the dollar is just slightly higher against other currencies.5 Still, the S&P 500 is up about 140% over that time frame compared to about 90% for European/international markets.1 These are great returns over just 4.5 years’ time, but the divergence persists.
What is happening to these two markets? First, the U.S. market has become much more expensive than the international market. This happens as the price of one market (the U.S.) moves higher much faster than its earnings. Secondly, those prices are moving higher because U.S. investors are assuming that we are on the threshold of an AI boom in profitability and productivity. So far, spending on generative AI continues to accelerate with not much to show for it, although there certain some areas in which AI is helping improve productivity.6
Whether you consider price to cash flow, price to book value, price to sales, price to dividend, etc., price has historically been a good predictor of future returns. The higher the price, the lower the expected returns are typically. Being diversified means owning some of the more expensive parts of the market, but also owning parts of the market that are more normally priced, such as today’s international markets following a divergence in recent returns. If you have any questions, please contact your Exencial advisor.
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The S&P 500® Index (S&P 500®) is widely regarded as the best single gauge of large-cap U.S. equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization.
The MSCI Europe Index captures large and mid-cap securities from 15 developed markets in Europe. The index covers approximately 85% of the free float-adjusted market capitalization across the European developed markets equity universe.
The MSCI EAFE Index is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada. The index is available for a number of regions and market segments/sizes and covers approximately 85% of the free float-adjusted market capitalization in each of the 21 countries.