Time to Travel?

The US stock market has consistently outperformed non-US stocks for more than a decade.  The phenomenon persisted despite an occasionally large (and maddening) valuation advantage for non-US stocks. So why are Atlas Capital Advisors advocating non-US stocks now? This note will discuss the sources of persistently strong US stock market performance and why, at least for the next quarter, we think the performance advantage lies outside the US.

The multi-year outperformance of US equities has been remarkable both in magnitude and in consistency. The chart above shows the ratio of the US equity index (S&P 500) to global equities outside the US (MSCI All Country World Index, or ACWI, ex-US)[1].  Since September 2007, the S&P 500 index has nearly tripled, while ACWI ex-US did not rise at all.  The S&P 500 had a higher return than ACWI ex-US in every rolling three-year period for more than a decade.

The most important reason why US equities have led the global stock market for so long is earnings growth has been much higher.  From September 2007 to September 2021, the average growth of the earnings per share of the S&P 500 was 4.6% per year, while the EPS of ACWI ex-US had an average decline in EPS of 1% per year.  That’s right, the EPS of ACWI ex-US is lower now than it was in 2007!  As one might expect, the earnings advantage for US equities is rooted in the remarkable growth of the US technology giants.  Amazon, Apple, Netflix, Nvidia, and Alphabet (Google) each grew earnings by more than 20% per year since 2007.

Additionally, US equities have had stronger returns than non-US equities because P/E ratios (Price/Earnings) have risen more in the US.  Fourteen years ago, the US stock market P/E was 17.1x while ACWI ex-US had a P/E of 16.1x; a ratio of US P/E to non-US P/E of 1.06.  At the end of September 2021, the US P/E was 25.8x while it was 17.7x for ACWI ex-US – the ratio has expanded to 1.45.  That rise in the gap between US and ex-US stock market P/E ratios led to an added 2.3% per year advantage for the US stock market.

For the non-US stock markets to finally start outperforming the US stock market, there must be a sufficient combination of:

1. Non-US earnings growth becomes closer to, or better than, US earnings growth
2. The price/earnings ratios of the regions converge

There’s some evidence that non-US earnings growth rates are becoming more comparable to US EPS growth rates.  The chart below shows the five-year EPS growth rates by region[2].  Earnings outside the US were more affected by the COVID pandemic than in the tech-heavy US stock market.  But the rest of the world is catching up, with trailing five-year EPS growth rates getting nearer to (but not yet better than) US EPS growth rates.

[1] Source: Bloomberg, SPX for S&P 500 and MXWDU for ACWI ex-US, December 1996 ratio set to 1.

[2] Source: Bloomberg. Current EPS compared to the average EPS in the period from 4 to 6 years past.

There’s no evidence yet of price/earnings ratios converging. The non-US earnings rebound mentioned above has been accompanied by falling P/E ratios outside the US. The US stock market reasonably should have a higher P/E ratio if the earnings growth rate is going to continue to be higher.  The gap in P/E ratios (25.8x US vs. 17.7x non-US) is justified if the future earnings of the US stock market will grow about 2% per year faster than the non-US stock market.  Since US EPS has grown more than 5% per year faster than non-US EPS for fourteen years now, we should not dismiss the possibility that US earnings growth will continue to be faster in the future.  But it would be unusual for one region to always have better earnings growth.  In the ten years ended December 2007, non-US stock markets enjoyed earnings growth more than double that of the US (13.7% per year vs. 5.6%), which drove the outperformance of the non-US markets[1].

The Atlas approach to choosing global equity regional weights does not rely upon forecasting earnings growth rates, which are notoriously difficult to accurately predict.  Based upon academic research and our own work, we have determined that Value and Momentum are the attributes which have the most bearing on what comes next for regional stock market returns.

The Atlas approach for determining Value is more comprehensive than most Value methods used in the industry.  We include the important price-to-something ratios, as well as some proprietary inputs.  The chart below indicates the Atlas assessment of Value of the US and non-US stock markets since 1996, where higher numbers indicate more favorable Value.  As the chart indicates, for the past 25 years the non-US stock market has nearly always had equal or better Value than the US stock market.  In recent months, the Value advantage of non-US equities has begun to widen again, reaching one of the wider gaps of the past decade.

[1] Source: Bloomberg, Atlas analysis. SPX for S&P 500, MXWDU for ACWI ex-US, earnings translated to US dollars.

The Atlas process also uses Momentum, an indication of local currency price performance over the prior year (adjusted for risk). The use of Momentum in combination with Value helps determine when to commit to the market with better Value.  The market with better Value ought to outperform, but it is better for investors to make the commitment once the outperformance is already underway.

The bubble chart below shows Atlas Capital’s Value and Momentum assessment for each equity market region as of the end of September.  The size of the bubbles on the chart indicates regional market capitalization weights.  Based on this assessment, stock markets in the European and Asia/Pacific regions have much better Value than the US with about the same Momentum.  Therefore, our Value/Momentum composite favors Europe and Asia/Pacific over the US. The equity region with the least favorable score is Emerging Markets, due to the negative price Momentum combined with so-so Value.

The experience of the past decade indicates how making regional choices in the stock market based on Value alone can lead to disappointing results.  Value metrics for non-US equities relative to US were occasionally tantalizing, and yet the US stock market continued its dominance.  Rather than rely on Value alone, our evidence indicates that allocators can improve their odds of success by combining Value with other factors, particularly price Momentum.  We also believe it is helpful to revisit these rankings on at least a quarterly basis since stock markets can change meaningfully in a short period. Based on the information with the most bearing on stock market outcomes, we believe it makes sense for the next quarter to move equity weight outside the US – to developed markets, not to emerging markets.  But there is not sufficient basis to “call the turn” and predict that a long stretch of non-US outperformance lies ahead.