Why are US equities overperforming? Five reasons

As the Helsinki stock market continues to stagnate, more and more investors are turning their attention to the United States. There's been a real rally in the American stock markets: The Nasdaq technology index is up by 60% since the bear market bottom in December 2022. The S&P 500 has reached new highs. Although European stock markets have also performed reasonably well recently, Europe has lagged the U.S. significantly since the financial crisis.

I have several times in the past touched on the reasons why European stock markets, and indeed other stock markets around the world, have lagged behind the US. 

i)               American companies are more profitable. The S&P 500 index has a return on equity of just under 20%, compared to a range of 10-13% for the rest of the world. So a dollar invested by an American company yields a better return than, say, a euro invested by a European company.

ii)              US companies grow faster. Forward earnings per share for the S&P 500 index have risen 185 % since 2006, or around 6% per year. Over the same period for which data are available, the MSCI World ex USA index EPS (i.e. world equities excluding US equities) is up by a modest 32%. Performance levels remain lower than before the financial crisis.

iii)            American stocks are trading at ever expanding multiples. This is partly justified by the faster growth rate of ROE and earnings. Thus, the cash flows discounted to today are more valuable than on other exchanges. But valuation multiples cannot stretch forever. The P/E ratio of the S&P 500 index, based on 12-month forward earnings forecasts, was 15x in 2006 and is now 21x. So on top of earnings growth of just under 6%, investors have seen valuation multiples stretch by almost 2% per year. If over the next ten years US equity valuations were to decline towards the rest of the world (15x), there would be a corresponding -3% drag on annual equity returns.

iv)            American stock markets are more dynamic, in a more dynamic economy. Social media platforms, ecosystems and now, most recently, AI innovations come from America. We all knowingly or unknowingly encounter Microsoft, NVIDIA, or Apple products every day. Instead, China has dragged its own tech giants Tencent and Alibaba into the mud. Europe knows how to slow down and regulate development, but it doesn’t know how to create tech giants. Europeans are cashing in their savings: 14 trillion euros are sitting in bank accounts here. In the US, by contrast, savings are more aggressively invested in stocks and used to finance new start-ups. Europe's IPO market has dried up, and private equity firms are buying companies mainly off the stock market. On top of that, the US economy is one the fastest growing in the world over the long term, thanks to a growing population and decent productivity growth.

v)              American stock markets have become the stock market of the world. The S&P 500 index seems to be sensitive to global liquidity developments. With China's economic growth model failing, the main challenger to the US economy doesn’t look like the threat it once was. There is a huge flow of savings from the rest of the world into the US, and the US stock market has effectively become the stock market of the world. Until these flows are reversed, US stock markets will continue to be fueled by other countries' appetite for American financial assets. 

As I suggested above, the US overperformance may not last forever.

Even US equities have grown by "only" 6% over the longer term (analyst consensus EPS 1997-2024. Actual performance over the past 70 years, according to data from Bloomberg, has grown by about 6.5%). Of course, this already takes into account share buybacks. The dividend yield on the S&P 500 index is a meager 1.3%. Even if earnings growth continues on the same trajectory (despite the inevitable slowdown in the global economy, where earnings are generated...), a mere reversion to 15x valuation multiples would slow total returns. With US equities, therefore, one has to believe that the excellent performance will continue well into the future.

The rest of the world is unlikely to remain on the sidelines while American tech giants rake in all the cash. Total dominance by American AI giants is hardly the ideal situation for the Chinese and Europeans. The dominance of the tech giants is no laughing matter, even in the US. For example, Epic Games CEO Tim Sweeney, a frequent critic of the tech giants (although Epic does have an axe to grind), tweeted as recently as Tuesday that “tech companies gained monopoly power and confiscated opportunity from all of the other US and European companies.”

Of course, the success of the tech giants, or the "Magnificent 8", as the winning bunch like Apple, Microsoft and NVIDIA are retrospectively called, does not fully explain the success of the US stock markets. But without them, the success of US stocks would be less dazzling. The return of the S&P 500 index (where the weight of mega companies is already 30%) over the last 10 years has been +230%, but without the "Mag8" it would have been +155%. By comparison, the Euro Stoxx 50 returned only +60%, but Japan's Nikkei225, for instance, returned +180% over the same period.

For future US stock market returns, the Magnificent bunch is a double-edged sword. They are undoubtedly the best companies in the world. At the same time, they operate in a huge market that attracts constant competition, challenge, and regulatory scrutiny. They also compete with each other. For example, Microsoft is hardly willing to rely indefinitely on NVIDIA’s supercomputers, where NVIDIA is currently striking gold, and is instead developing its own chips.

Tesla's long-term competitive advantage against the avalanche of cheap Chinese electric cars remains in question, although Tesla fans see the company as more than just a traditional low-capital-return automotive challenger. Apple's core product, iPhone, is not growing and faces increasing headwinds in China. Alphabet has not attracted significant new money streams beyond its Google search engine, while ChatGPT's challenge to Google's ad-infested search pages is interesting to observe. Amazon is in a never-ending investment war against every store in the world, and behind its crown jewel AWS are Microsoft's cloud services (I also can't think of anyone who could credibly challenge Microsoft at the moment...).

The challenges have not gone unnoticed by investors. Ironically, even Nasdaq Helsinki has outperformed Tesla (-27%), Apple (-8%) and Alphabet (-2%) over the last six months.

While the US stock markets are attracting investors' attention and capital, there are interesting opportunities for stock pickers in other parts of the world. Stocks are cheap and there isn’t much competition for them in Europe or Finland.

Sentiment is poor, especially in our own Finnish stock market. Just a few years ago in the bull market, investors were bragging about how they were going to buy the dip. Now that there has been dip after dip after dip, they have suddenly become very quiet. These are good times to increase your ownership in quality Finnish companies.