The notion that U.S. equities enjoy a favorable market, economic and regulatory environment is broadly accepted in both the American and European investment world after 15 years of consistent U.S. outperformance. Indeed, the U.S. has outperformed most other developed markets by about 150% on average over that period.
In a quarterly letter to clients entitled “American Unexceptionalism,” Ben Inker and John Pease of the Grantham Mayo asset allocation team take exception to this popular narrative, arguing that without mega-cap technology stocks, the U.S. market would be positively pedestrian. Throughout the letter, the two refer to the popular Magnificent Seven as the Magnificent Six, omitting Tesla because that company does not display the financial strength of the rest.
“The common wisdom is that if you invest in U.S. equities ‘for the long term,’ you’ll compound capital at somewhere between 9% and 12%. Going outside the U.S., by contrast, is generally seen as needlessly risky: returns in the rest of the world have been somewhere between awful (China) and uninspiring (Europe) since the GFC, and it is a fact that no economy today can boast of the resilience we have seen in post-pandemic America,” Inker and Pease write. “The reason people are bulled up on the U.S. stock market is therefore quite straightforward: the U.S. has had a rip-roaring economy, and domestic equities have massively outperformed every other broad stock or bond index for over a decade.”
They say the move to U.S. is the result of three primary factors. The first is the rally in the U.S. dollar. The second is valuation expansion, which they say picked up steam after 2015. Finally, they say, is fundamental outperformance driven by dividends, buybacks and economic growth.
However, Inker and Pease argue that 80% of U.S. outperformance comes from “sources of return that are unlikely to repeat: the dollar strengthening against almost every currency in the world and relative valuations expanding.”
The valuation issue is a major area of focus for the two managers. “U.S. valuations are already quite high — somewhere between the 90th percentile on simple ratios like P/E and closer to their all-time records when contrasted with the opportunity cost of investing in other assets (like Treasuries),” they write. “Valuations could become more stretched, of course, but it pays to remember that higher valuations always beggar future returns.”
But as they see it, U.S. companies have been coasting on factors that have become less compelling. In particular, they maintain that most fundamental U.S. outperformance happened before 2015 and most of it “was provided by a few giant companies.”
That’s when the picture began to change. “If we start the clock in December 2014 instead of December 2010, the U.S. fundamentally outperformed the rest of the developed markets by a smidge: an aggregate 3.8%,” they say. “Fast-forward to December 2019, and the fundamental outperformance since then is nil. Any additional growth that U.S. companies were able to muster was simply not impressive enough to out-return their international peers.”
The benefits from dividends and buybacks become diluted as valuations rise, they wrote. “If you trade at a P/E of 10x and pay all your earnings to investors, they make 10% on dividends. If you trade at a P/E of 25x, they make 4% instead,” they explain in a footnote.
The two senior managers at Grantham Mayo acknowledge they have underperformed because they have favored other asset classes outside of U.S. mega-cap tech. “To be completely transparent, we were surprised by these numbers,” they wrote. “We know that since 2019 some of the largest companies in the S&P 500 have been able to deliver extraordinary fundamental growth. The Magnificent Six, 8 which were all among the top 50 names by market cap in the S&P 500 five years ago, delivered amazing gross and net profit growth in the intervening years, and contributed a lot of return to investors in the index.”
However, they reason that the U.S. equity market may well have peaked for three reasons. First, tariffs are a regressive tax and “almost certainly a net drag on domestic demand because poorer households spend a larger portion of their income than the rich do.”
Second, the labor supply, which increased dramatically in the post-pandemic years due to new entrants to the labor force from new workers and immigrants. Now more people are retiring and immigrants are leaving the workforce.
Finally, uncertainty is likely to make global investors look to other, less expensive markets. “Shifts in government policies risk turning expensive investments into stranded assets and discouraging corporate investment, just as greater uncertainty about the future employment situation leads to lower spending by households,” Inker and Pease argue.
