The Illusion of American Market Dominance: A Deeper Dive
This article analyzes the historical performance of the U.S. stock market compared to international markets, examining whether its past outperformance is sustainable and what factors have contributed to it. It explores the role of valuation changes and the potential risks of relying solely on past trends.
The "Trendsetter" Investor Mentality
Some investors prioritize following market trends and investing in popular sectors, particularly U.S. large-cap tech stocks. They are driven by the desire to be seen as current, informed, and able to engage in trendy conversations. The allure of being a trendsetter can overshadow more traditional, diversified investment strategies. This approach dismisses broad market indices and factor-based investing as boring, preferring instead to chase the latest disruptive technologies and high-growth industries.
This pursuit of being a "trendsetter" can lead to concentrated portfolios heavily weighted in specific sectors, often fueled by admiration for figures like Elon Musk. The investor wants to discuss these companies and show knowledge of their industries.
Dissecting US Market Outperformance
To accurately assess the true lead of the U.S. stock market, a thorough analysis is needed. This involves breaking down the market's returns relative to global non-U.S. developed and emerging markets. A key method is performing a regression analysis of market returns against valuation changes, allowing us to determine the underlying average return of the U.S. market, independent of valuation fluctuations.
This analysis uses statistical and quantitative methods to dissect the factors driving U.S. market leadership, revealing data that might differ significantly from perceived wisdom. This data highlights the potential volatility and complexities hidden beneath headline figures.
The Role of Valuation
Since the 1990s, U.S. stock valuations have significantly outpaced those of the EAFE (Europe, Australasia, Far East) index. In the 1980s, the valuation ratio was around 1x, but by 2022, it had surged to nearly 1.8x before falling back to around 1.5x and then increasing to 1.7x-1.8x in early 2025. The increase is the ratio of the valuation of US stocks compared to international stocks.
This highlights the impact of valuation expansion on reported returns. When considering valuation changes, the annualized excess return of U.S. stocks over the EAFE index is 4.6%.
Regression Analysis: A Different Perspective
After adjusting for valuation changes through regression analysis, the annualized excess return of U.S. stocks drops dramatically from 4.6% to 1.2%. This 1.2% is statistically insignificant, suggesting that the perceived long-term dominance of the U.S. market may be smaller than commonly believed. The bulk of the U.S. market's outperformance in the last 30 years comes from investors' willingness to pay a higher premium for U.S. stocks, not from fundamental improvements in company performance.
Therefore, the excess return of the U.S. stock market in the past three decades is not necessarily due to improvements in the fundamentals of US businesses.
Has U.S. Dominance Been Consistent?
Examining the past five decades (1970s, 1980s, 1990s, 2000s, and 2010s) reveals that the U.S. market only outperformed global international markets in two of those decades. In fact, the U.S. market underperformed in the 1970s, 1980s, and the "lost decade" of the 2000s. Much of the outperformance has been concentrated in the last 15 years.
An AQR study, analyzing data from 2008 to 2022, showed a similar pattern. The annual average excess return of U.S. stocks was 4.7% relative to the currency-hedged EAFE index. However, after controlling for valuation changes, the annual excess return decreased to 1.2%, a statistically insignificant value. This consistency across different timeframes reinforces the findings.
Interpreting Valuation Changes: A Guide for Investors
To understand the implications of these valuation shifts for investors, it's crucial to recognize the two primary ways a market can outperform another:
- Fundamental Growth: Stronger corporate earnings, economic conditions, and innovation. This growth is sustainable.
- Valuation Expansion: Investors are willing to pay a higher price for the same market.
The US's outperformance in recent decades has primarily been due to the second factor, valuation expansion. While a market's superior fundamentals can provide a sustainable lead, outperformance based on expanding valuations is unsustainable. Investors should therefore exercise caution.
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Caution is necessary: If a market's excess return is driven by valuation expansion, it's unlikely to be repeated indefinitely.
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Mean Reversion: Extreme valuations tend to revert to the mean over time.
The Perils of Momentum Investing at Extreme Valuations
Investors should be wary of extrapolating past market trends, especially if they are based on valuation expansion. Treating these trends as guaranteed future outcomes can be a form of momentum investing at the wrong time, which is particularly risky when valuations are already at extreme levels.
In 2025, non-U.S. international markets possess a combination of low valuations and upward momentum. The U.S. stock market, conversely, has high valuations and faces potential momentum reversal. The combination of these two makes non-US international markets more appealing.
A "Sinner Little" Strategy: A Contrarian Approach
One speculative strategy involves betting against current trends. This would entail buying VGK (Vanguard FTSE Europe ETF) or VXUS (Vanguard Total International Stock ETF) and shorting QQQ (Invesco QQQ Trust) or VTI (Vanguard Total Stock Market ETF). Buying undervalued markets that have upward momentum, and shorting overvalued markets with reversing momentum, can be a potentially lucrative strategy.
Such a strategy would offset market risks and capitalize on valuation disparities. However, this approach is inherently risky and considered extreme.
The Safer Path: Global Diversification
Despite the potential for short-term gains from contrarian strategies, a more prudent approach is global diversification with a focus on long-term holdings. This means including both high- and low-valuation markets, as well as those with upward and reversing momentum. Historically, markets with both low valuations and upward momentum have demonstrated high expected returns.
Value is a key factor that can create a winning strategy, but a combined low valuation and momentum strategy can be especially powerful.
Overweighting US Stocks: Assessing the Risks
Investors who heavily allocate to U.S. stocks need to consider the "holding cost disadvantage." Even without a mean reversion, the U.S. market would need to sustain higher earnings growth rates or further valuation expansion to justify its current lead over non-U.S. markets. The need to continually increase valuations is unsustainable long-term.
Why Past Winning Industries Often Underperform
Selecting winning industries is challenging, especially when chasing past leaders. High-growth industries are often characterized by:
- High Valuations: Their stock prices are expensive.
- High Expectations: If future earnings don't meet expectations, valuations will fall to more reasonable levels.
Focusing too heavily on a single industry also introduces uncompensated industry concentration risk.
Furthermore, the historical data of the past 50 to 60 years (1970-2024) on annualized returns of industries in the US stock market show that only one-third of them (blue bar) have won against market indices. The other two-thirds (green bar) have failed.
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More Competition: Successful industries attract new entrants, diminishing excess profits.
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Earnings Dilution: Companies may issue new shares to defend against competitors, diluting earnings per share.
Counterintuitively, industries with slow growth, like firearms and tobacco, have historically delivered surprisingly high returns.
The Disconnect Between Innovation and Investment Returns
While technological innovation drives economic growth and progress, it doesn't automatically translate to superior investment returns. Many investors are intuitively drawn to high-growth companies, they believe that these companies are driving technological revolutions and human civilization, and can follow such revolutions to win in the stock market. However, they fail to understand that economic and human advancement are not necessarily tied to our investments.
Therefore, a more nuanced approach is needed to assess investment opportunities and to resist the allure of simply chasing the latest trends. The key thing to consider is whether innovation and technological advances necessarily equate to guaranteed investment returns.