AAPL Apple Inc

By James Mackintosh 

Rank the performance of stock markets over the past decade and, in rough approximation, these are the results: U.S. first, everywhere else way behind.

Bears often argue that U.S. market exceptionalism is a bubble, especially with valuations as high as they are.

However, the primary reason for the outperformance of U.S. stocks is that America itself has performed far better this decade than other places. Its economy has beaten those of most other developed countries. Its companies have led in new disruptive technologies. It has avoided the crises that have hit Europe and many emerging markets. It fixed its banks after the recession more quickly than Europe. And -- perhaps thanks to a lack of antitrust enforcement -- earnings have soared, even as the dollar has done well.

Fundamentals matter, and America's fundamentals have just been stronger.

Yet there are two reasons to doubt the sustainability of this outperformance. The first is that performance tends to go in cycles, as governments shift policy, companies rise and fall, and technologies develop (remember that the standard mobile phone of the 2000s was designed in Finland, not California).

The great decade for the U.S. followed a terrible decade in the 2000s, when U.S. stocks lost money even with dividends reinvested, and beat only Japan among large markets. Over the past two decades together, the U.S. sits in the middle of the pack of significant markets, ahead of Japan, the U.K. and eurozone, but behind Canada, Australia, Sweden, Switzerland and emerging markets. (Throughout this article performance is considered in dollar terms including dividends.)

Second, it's historically rare for richly valued markets to hold on to their valuation premium over many years, and the U.S. -- thanks to a handful of very large technology companies such as Apple, Amazon, Facebook and Alphabet -- is richly valued compared with the rest of the world. If the next decade is a repeat of the one now ending, maybe the U.S. can stay ahead.

But the next 10 years are likely to bring big changes, political turmoil, new technologies and a shift from reliance on monetary policy -- which is hobbled by low interest rates -- to a bigger role for government stimulus in determining market direction. Not only does the U.S. have to weather these changes better than other markets, it has to do so by enough to justify retaining its premium valuation.

The real drivers of the U.S. lead are the massive outperformance of economically sensitive cyclical sectors such as industrials, consumer discretionary and financials; the predominance of tech companies within the U.S. market; and the strong dollar over the decade.

The dollar started out the decade badly, falling in 2011 to its weakest against trading partners in modern history amid fears that a debt-ceiling standoff between the White House and Congress could lead to a default. In the end there was no default, but the loss of the government's coveted triple-A credit rating that August marked the low point for the currency. The stronger economy and trouble elsewhere helped the dollar rebound more than 33% since then, putting it above its average exchange rate since 1970, according to JPMorgan Chase's inflation-adjusted trade-weighted currency index.

Fundamentals drove investors to buy the U.S., but American stocks did far better than the performance of the U.S. economy or even global earnings of U.S. companies would justify on their own. It is at least doubtful that such a performance can be repeated.

Three things happened. American companies increased profits from abroad in a spectacular way, helping S&P 500 profit margins to a record last year even as corporate profit margins within the U.S. slumped from their 2012 peak to below where they stood at the end of 2009. With politicians turning against globalization, low-tax countries under pressure and foreign regulators turning their attention to the high profits made by some of the largest U.S. companies, simply maintaining margins would be a positive outcome.

Big tax cuts boosted earnings, something unlikely to happen again given how low U.S. corporate taxes now are.

And valuations soared. At the start of 2010 the U.S. market was valued at 14.5 times expected operating earnings over the next 12 months, according to I/B/E/S Estimates. That has now jumped to almost 18 times, valuing the U.S. market much more highly than the eurozone, U.K., Japan or emerging markets. The rise in valuation in the U.S. was also far bigger than elsewhere (forward price-to-earnings ratios for Japan and emerging markets fell over the decade). Price-to-book multiples in the U.S. have also jumped.

If the S&P valuation rose by the same amount again, it would take the forward P/E ratio to 21, a level reached in data since 1985 only during the dot-com mania of the late 1990s. It's not impossible, but it would require a big bubble, something that doesn't happen often.

Of course, if the next decade brings more natural disasters, political unrest and currency crises, the U.S. may well benefit from its relative stability. Even then, it would be foolish to expect a repeat of the wonderful bull market of the past decade.

Mr. Mackintosh writes The Wall Street Journal's Streetwise column. He can be reached at james.mackintosh@wsj.com.

(END) Dow Jones Newswires

December 17, 2019 21:05 ET (02:05 GMT)

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