The S&P500: A reality check for investors

Key Takeaways:

• While the U.S. market has historically delivered impressive returns, recent outperformance may not be sustainable, with much of it driven by valuation expansion rather than fundamental improvements.

• The U.S. outperformance is a relatively recent development, not a constant trend throughout history.

• We must keep in mind that the market is very good at pricing in widely known information, like the fact that the U.S. is a great country to do business in.

• Diversification across international markets remains crucial to mitigate risks associated with localized economic downturns and geopolitical events.

Amazing returns

Over the past 50 years, the U.S. market has outperformed the rest of the world by a serious margin of 1% per year. The U.S. market returned on average 9.8% vs. 8.7% for International Markets (IM) all while maintaining lower volatility at 15.2% versus 17% for IM! (link 1). $100 invested in 1970 in the U.S. grew to $22k as of January 2024. Whereas those $100 invested in the EAFE index, which tracks 21 developed countries excluding the U.S., grew to ‘only’ $11k.

Figure 1: USA vs EAFE total returns

Source MSCI.com. 1970-2024. Green = USA, Orange = EAFE. link 2

Why would anyone want to invest in anything else than the U.S. stock market? The Oracle of Omaha himself even advises to ‘never bet against America’. Well, let’s delve a bit deeper and look at a case for international diversification.

The U.S. Market Dominance is a Recent Phenomenon

Picture this: We rewind the clock to June 2013. If you had invested $100 back in 1970, both the U.S. market and the EAFE index would have yielded nearly identical returns – both around $5.7k. The significant U.S. outperformance emerged only in the last decade (link 3).

The chart below shows this same point in a different way. You can see that throughout the past 50 years, the U.S. has shown the most persistent outperformance only in the last 10-15 years. Before that, it has been like a pendulum swinging back and forth between the U.S. outperforming and underperforming. If history is a guide, it is a matter of when, not if, international markets will catch up again.

Figure 2: U.S. outperforming and underperforming international markets

Source Vanguard: link 1

Moreover, data from 1900-2022 by Dimson, Marsch, and Staunton show that contrary to popular belief, Australia has delivered the best overall real performance. So, if we would just look at the best past performance maybe we should opt for 100% in Australia (link 4). Or if we go by size, in 1989 Japan was the largest market by a wide margin. Had we concentrated solely on the largest market at that time, the outcome would have been sobering: Japan's main stock market index, today in 2024, has finally surpassed its all-time high after a massive 34-year bear market (link 5). The phenomenon of U.S. dominance is a relatively recent development, and recency bias may lead investors to overlook the broader historical context.

The U.S. Market is Expensive

Let’s dig a bit deeper into the outperformance over the last decade. What are the drivers of the returns? Is it grounded in improvements in fundamentals or is it because security prices have inflated? It turns out most of the outperformance has been due to valuation expansion (link 6).

Let’s consider the Shiller CAPE, a measure of stock 'expensiveness' relative to its cyclically adjusted earnings. For the U.S. market, it has surged from 21 to 34 in the past 12 years, while the EAFE CAPE has remained relatively stable between 15 and 20 during the same period (link 7).

What does this mean? Essentially, it indicates that the remarkable run-up in U.S. market performance over the last decade is less about underlying company fundamentals, like increased profits or operational efficiencies, and more about the market's willingness to pay a higher price for those earnings.

Today the U.S. is expensive compared to its own history (with the long-term average being 17 (link 7)) and compared to most other countries (based on the comparison above). Does this mean that future returns will be lower? It's a complex question, but historical data demonstrates a negative correlation between PE and subsequent 5-year returns. The more you pay now, the less you may earn later:

Figure 3: PE ratio and subsequent performance

Source JP Morgan: link 8

The U.S. is a great country for business, but everyone knows this

Okay but maybe, one might think, the U.S. is such an exceptional country that it does not matter that securities are becoming more expensive. High valuations might be justified by the country's exceptional economic environment and business climate. The U.S. economy has historically been characterized by innovation, entrepreneurship, and a robust regulatory framework that fosters business growth.

However, the thing is - the market already is fully aware of that and has likely priced it in. Betting on future U.S. outperformance would be a bet on these strengths in excess of the expectations that the market has already priced in. That’s an important nuance to the story of American exceptionalism.

The S&P500 is full of multinationals, but...

Finally, let’s address the argument that “U.S. companies do business around the world, so the S&P 500 is actually a global index.” While this argument seems plausible, it does not hold up empirically. The stocks of multinational firms typically move closely with their respective national market indices, making them poor tools for diversification. Adding international equities to the domestic index provides substantial diversification improvements (link 9).

Besides, one could argue that a big aim in investing is avoiding catastrophic outcomes, which are more likely to occur to one country than to all countries. It is not hard to think of scenarios where the U.S. would be disproportionally affected by an event, such as a major natural disaster or a war. These types of risks are diversifiable.

Why do we want to diversify internationally? Diversification is key in investing because it helps eliminate idiosyncratic risk—risk unique to a specific company or country—which isn't typically rewarded with higher returns. Harry Markowitz's mean-variance theory underpins this concept, which states that some risks are compensated, by delivering extra returns, and some risks are not. By spreading investments globally, we can mitigate these country-specific risks and only bear the systematic risks that are intrinsic to the broader market, and that we are likely to be compensated for.

Closing

To conclude, it’s been the explosive and dominant growth (and really the expected future growth) of the tech sector in the US, together with the valuation expansions, that has driven the superior returns of U.S. stocks over the last 10 years. If you believe that this performance is repeatable, that the market is still underpricing the U.S. despite decades of valuation increase, you are free to overweight (compared to global market cap weights) the U.S. or the U.S. tech sector, if you like.

Overall, based on the argument provided I feel most comfortable spreading my investment across the entire globe, but everyone is different, and for many, an investment in the S&P 500 or the total U.S. stock market remains an excellent choice.