For recent decades, valuations between major stock markets internationally have tracked each other fairly closely. However, since the 2009 financial crisis that relationship has broken down. The U.S. market now stands at around 30-40x a year of earnings depending on the metric you look at. In contrast the major markets such as Europe and Japan trade at around 20x-25x. I’m using round numbers here to illustrate the point, that the U.S. is now almost twice as expensive as other major developed markets. So what’s going on?

American Exceptionalism

There are a few things in favor of U.S. markets. The importance of tech in the economy is overwhelming and firms such as Google

GOOG
, Amazon

AMZN
, Appl

AAPL
e and Microsoft

MSFT
have a global footprint. They just happen to be U.S.-listed. Furthermore, these firms have great returns on capital, they can, and have, created growth by hiring a few more developers or buying a few more servers. That’s relatively efficient way to grow and maybe they deserve to trade at a premium for it. These firms matter because the represent about a quarter of the value of the S&P 500. So the U.S. has benefitted from the success of tech.

Secondly, maybe investors just have more faith in the investor-friendly policies of the U.S. economy, and maybe the way the Covid-19 crisis has been handled, or the loose money approach taken by the Fed and Congress.

Turning Japanese

Still, there are concerns. It’s hard to look at historical country valuations without noticing the experience of Japan in the late 1980s. At the time Japanese stock returns and valuations were through the roof. Japan was seen as the global model for business and could do no wrong. Japanese eye-popping valuations didn’t last. Now Japanese returns are well below other markets over recent decades. The Japanese bubble popped.

Future Returns

Ultimately returns are grounded in math. You can grow, and pay-out, earnings or you change your valuation level. That’s really it for determining stock market returns.

Earnings growth rates are generally known over time. High single-digit percentage rates of earnings growth are pretty standard for developed economies.

That leaves valuation. Here big swings are surprisingly common. There’s a big catch though, over long spans of history more expensive markets can fall in value, and vice versa. That doesn’t bode well for the U.S. though the timing is uncertain.

International Diversification

International diversification isn’t a bad idea even without valuation differentials. Maybe Mexico has a good year when Brazil has a bad one. Holding a basket of different countries can help manage risk..

On top of this, the apparently stretched level of U.S. valuations does mean that looking oversees may be prudent. It could take a few years, but historically the expensive valuations of the U.S. market may come back to Earth, just as we saw with Japan in the early 1990s. The U.S. has had a great run, but investors should consider their options globally. Europe and Japan are obvious places to start with large developed markets on less demanding valuations.

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