OK, here's a quick rundown for anyone with a 401 (k) or other retirement portfolio.
As we all know, the US funds in our portfolios have been outperforming international funds for months, years, and more than a decade. For example, in the past five years, US equity index funds such as the SPDR S&P 500 ETF
and the Vanguard Total Stock Market Index Fund
have achieved roughly twice the total return of internationally oriented equivalents such as the iShares MSCI EAFE (Europe, Australasia and Far East) ETF
or the Vanguard Total International Stock Index Fund
Go back to early 2010 and the US funds beat their international counterparts by four to one.
Data from MSCI, the stock market data company, shows that this performance gap dates back decades.
So here is the question.
That's it. Why did US equity funds outperform international equity funds so much?
This is the challenge hedge fund Honcho Cliff Asness addresses in a remarkable new analysis titled The Long Run Is Lying To You, brilliantly. And what he finds helps turn what is conventional wisdom on Wall Street and Main Street upside down through our retirement accounts.
If you think U.S. funds are doing so much better because U.S. companies have had more and faster growing earnings per share than their international counterparts, think again, Asness reports.
If you think U.S. companies made higher and faster growing dividends, that's broke too, reports Asness.
In fact, using 1980 data, it shows that the earnings and dividends of U.S. and international stocks (and funds) were largely in line. US companies' superior underlying performance accounts for a small fraction of their better returns.
The real explanation? Price.
From 1980 to 2020 Asness writes: "We see that the US is becoming relatively expensive with the US," writes Asness in comparison to the rest of the world. Investors are simply willing to pay far more for every dollar of US profit than they would for international corporate profits.
He illustrates this using one of the most popular metrics on the stock market, the so-called cyclically adjusted price-earnings ratio, which compares the price of a share with the company's net earnings over the past 10 years.
In 1980, US and international stock indices traded for roughly the same CAPE, Asness reports. Today the CAPE in the US market is twice the international average. This shift is gigantic – and in addition to any changes in income. It is not so much that US earnings have risen so much more than international earnings, but that US stock prices have risen much more than international stock prices relative to their earnings.
In the 1980-2020 period, this “valuation shift” accounted for about 80% of the total US outperformance, according to Asness. And as of 1990, a Halcyon period for US stocks due to the collapse of the Japanese bubble, it's still around 75%.
In other words, US stocks didn't get more popular because they performed so well: they performed so well because they got more popular. We investors all offer the price of US stocks because we believe they are "better," and by increasing the price we make them look better … which makes more people want to raise the price even more.
To my naive ear, this sounds suspiciously like a legal Ponzi scheme or a pyramid scheme or a bubble.
For those who were baffled by the brain teaser above, here's a do-over chance. Just as US equity funds outperformed international equity funds in our portfolios, so exciting go-go growth funds have outperformed boring value funds. (So-called “growth funds” invest in (expensive, but rapidly growing) companies of tomorrow such as Tesla
Whereas “value” funds invest in (cheap but slower growing) companies of today and yesterday like Ford
Since the beginning of 2010, for example, the Vanguard Growth ETF
has achieved 75% higher returns than the Vanguard Value ETF
In the last five years the growth has clearly exceeded the value by 100%.
But again: why?
Why were growth funds such a much better investment than value funds?
Asness runs the numbers and comes up with the same answer. This is not due to relative earnings growth or dividend payouts. Again, he says, it's the price.
This time around, he uses another popular yardstick to compare stock prices to the value of a company's net worth.
From 1950 to about 1990, U.S. growth stocks were on average four times as expensive as value stocks on this measure.
Today? They are ten times more expensive on average. This gap is as big as it was during the dot-com bubble of 1999-2000, he says.
In other words, it is the same paradox or the same illusion. We believe growth stocks have become more popular because they performed so well. But the main reason their performance has been so good is that they have become more popular. Growth stocks' investment vogue reflects less of their superior performance than of the cause. We are paying more and more for the privilege of investing in the hopes and dreams of tomorrow.
This means we must make heroic assumptions if we expect US stocks and growth stocks to perform as well in the future as they have in the past. Not only do you have to stay in style, you need to be even more fashionable. And heaven forbids if they actually go out of style.
Fortunately, fashion does not go in cycles and what is popular today will no doubt be what is popular tomorrow. Just ask a young person.