U.S. stocks have managed to flip one of the main tenets of economics on its head in the wake of the Great Financial Crisis. The U.S. stock market produced a world-leading annualized return of 12% from 2010 through the end of 2022 while maintaining a small deviation from the volatility of the global equity market as a whole, according to a new report from Morningstar.
In other words: U.S. stocks produced outsized returns with less risk compared to the rest of the world.
This feat is in part due to the dollar’s appreciation, favorable business conditions, and the rise of major tech firms during the last decade. But how can this history inform investment theses in the future?
VettaFi contributor Dan Mika spoke with Adam Sabban, a senior manager research analyst at Morningstar and a co-author of the report. The following interview has been edited and condensed for clarity.
Sector Exposures
Dan Mika: The U.S. and the rest of the world are split 50/50 between their shares of the top 500-performing companies, according to your research. However, U.S. companies only make up about 20% of the bottom 500 performers. What trends are driving this at a macro level?
Adam Sabban: Based on the time period that we’re looking at, we’re emerging from the financial crisis that officially ended around 2009. [However,] remnants of that crept up for Europe again around 2011. If you look at the pool of underperforming stocks outside the U.S., you’ll find a lot of banks, [and] you’ll find commodity-related companies. Part of that is reflected in a little bit slower recovery [for non-U.S. stocks] from the Great Financial Crisis [for non-U.S. stocks] than the U.S.
I think more broadly, the U.S. has had greater exposure to technology and consumer-facing companies. Those sectors generally have performed better, and that will be reflected in those charts somewhat. Naturally, if you’re in international equities, you’d have more exposure to commodity-related businesses. If there is a prolonged slump in energy prices, for instance, some of that is naturally going to bleed into some of these figures. I think the composition of the universes has something to do with it. But certainly company-specific factors are at play too.
Mega-Cap Influence
Dan Mika: You mentioned technology companies. In this report, you estimate FANGAM (Facebook/Meta, Apple, Netflix, Google, Amazon, Microsoft) — these types of major companies that really grew in the past decade — amounted to only about 22% of the U.S.’ outperformance. What explains the performance of comparatively smaller U.S. companies against their international peers?
Adam Sabban: The reason we wanted to pull those [large companies] out was because they’re commonly viewed as these return outliers that are supposed to be responsible for almost all of the overall U.S. market’s advantage. By pulling those out, we show that that has not really been the case. As far as the rest of the U.S. market, the over 1,000 companies outside of those [large stocks], why have they outperformed? It’s for a variety of reasons.
We broke out the attribution of the market by sector, for instance. You can see pretty much across all sectors that U.S. stocks have outperformed. It’s a variety of things that we dive into, from better earnings growth to stronger returns on capital. Those are probably the key drivers. Certainly multiple expansion, as we talk about in the paper, has a role to play. U.S. companies have seen their price multiples rise over time, to a greater extent than non-U.S. companies. That adds fuel to the fire from a total return perspective when you’re looking at it through the lens that we are, which is an earnings growth, plus multiple expansion, plus dividend yield model.
Effects of Interest Rates
Dan Mika: U.S. firms ran at a higher debt-to-capital ratio than non-U.S. groups during this period. In part, that’s because their stronger financial performance improved returns rather than dragging them. What effects will a 5% interest rate world have on these firms’ margins?
Adam Sabban: It’s definitely a different dynamic now where companies can no longer borrow at 2% or 3%. [There is no longer] a really low hurdle rate for the types of returns that they’re looking to get on their projects, or perhaps they were borrowing to buy back stock. In some sense, it’s a harder road for companies just more broadly in a higher interest rate environment. It could be different moving forward. The benefits to leverage are reduced when the price of leverage goes up. How that evolves remains to be seen.
We’re basically a year and change into this new interest rate regime. We stopped our analysis at the end of 2022. I think it’d be interesting to look at how things evolve in the future, even through this year, or perhaps through 2024. Are companies choosing to de-lever, given the higher costs of borrowing? What types of impact does that have on reinvestment or business or profitability?
It’s tough for me to speculate. But certainly looking backwards over the period that we analyzed, this was the time to borrow if you’re a corporation. These were the lowest rates that we will ever see, perhaps.
U.S. Economy Shows Resilience
Dan Mika: The report’s conclusion mentions mean reversion as one of the arguments for going overweight on non-U.S. stocks. I’m fascinated by how much that concept has been rebuffed by the U.S. economy in the past few years. The labor market and consumer spending have been resilient in the face of rate hikes and bank failures; inflation has fallen from its peak and most recently came in slightly cooler than consensus expectations; and we’re seeing more steam gather around the “soft landing” narrative. I wonder if any of this was on your mind as you and your colleagues were writing about the case for non-U.S. stocks based on a time frame that is mostly pre-pandemic.
Adam Sabban: Those are fair topics that you raised. When it comes to the longer-term outlooks that we outlined both in favor of the U.S. and in favor of non-U.S. stocks, these are longer-term considerations. When you think about mean reversion and valuations or currencies, if you look at the valuations in the U.S. and this prolonged run of outperformance, which basically is from 2008 onwards, that’s a very long cycle. You can have short cycles; you can have longer cycles. Typically for valuations, the discount between U.S. stocks and international stocks is not going to converge in a month. It’s going to take time.
U.S. Stocks Commanding Larger Premium
I don’t know if it’s necessarily the recent events, things that have popped up since the pandemic, [that] are directly impacting that line of thinking. I think it’s more so we’ve got 12 years of U.S. stocks doing very well, and they’ve been rewarded for it in market prices. There is a larger premium for U.S. stocks relative to international stocks than we’ve seen in other periods in history.
On a go-forward basis, if you’re looking towards the next 10 or 12 years, given that valuations tend to have some sort of mean reversion components to them, although it’s by no means guaranteed, you can certainly foresee things reversing course a bit, and slowly trickling the other way over time. I think the whole mean reversion topic is there; it’s more of a high-level, longer-term cycle as opposed to any consideration from one or two years. It’s a product of the aggregate of market activity that we’ve seen for 10 to 12 years now.
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