Europe and Japan | In America’s Shadow

It is one of the most valuable publications in the investment world Global Investment Returns Yearbook. It is an annual overview of the returns of various asset classes compiled by British economists Elroy Timson, Paul Marsh and Mike Stanton in association with Credit Suisse.

The yearbook contains not only summaries of returns on stocks and government bonds from dozens of countries, but also very interesting background articles on the development of these returns over the years.

In the 2023 edition, three economists discuss, among other things, the geographic evolution of stock markets. Their database of research goes back to 1900. According to economists’ calculations, in 1900 British stocks weighed 24% of the global stock market. At that time the US was only 15%. However, the importance of American stocks soon increased rapidly. The United States now accounts for more than 62% of the MSCI All Country World Index, along with 23 developed and 24 emerging market stocks.

With these figures in mind, it is not surprising that the US stock market is showing impressive returns. American asset manager AQR published an article in the middle of this year in the official journal Portfolio Management on the question of whether diversification in other regions is really effective. After all, over the past thirty years, the annual average return of U.S. stocks—adjusted for currency movements—has been no less than 4.6 percentage points lower than that of stocks in other developed countries.

Assessment

According to AQR, this yield difference has a very simple explanation. In 1990 – almost impossible to imagine – the valuation of the US stock market was significantly lower than the MSCI EAFE index of stock markets in Western Europe, Australia, New Zealand, Hong Kong, Singapore and Japan. This is, of course, a result of the overvaluation of the Japanese stock market in previous years.

AQR uses CAPE as the valuation metric. This price-earnings ratio, also known as the Shiller PE, is calculated using the average earnings per share over a ten-year period. In 1990, the CAPE of the MSCI EAFE Index was still higher than that of the MSCI USA Index, but by the end of 2022 the roles had completely reversed.

According to AQR calculations, over the 1990-2022 period, nearly three-quarters of the U.S. stock market’s valuation was attributable to high returns.

There are two ways the US stock market can beat other markets, the asset manager says. In fundamental terms – such as better profitability – but that has only been to a certain extent over the past thirty years, or investors have been willing to pay an increasingly high valuation for these fundamental qualities. AQR considers the latter unlikely because the estimation interval is already too wide for it.

According to AQR, a better regional spread than the current world indices offer is advisable. Something to think about for all equity investors, especially ‘passive’ investors in ETFs on world indices.