“Home bias” is one of the great money management foibles, but don’t tell that to U.S. investors. They have been favoring their domestic stock market and loving it.
The S&P 500 (.SPX) closed up almost 29% in 2019—its best annual performance since 2013. The Stoxx Europe 600, meanwhile, gained 23%. The difference over the past three decades is huge: Since 1988, as far back as data are available, the MSCI All Country World Index excluding U.S. stocks has delivered an 860% return, whereas the MSCI USA has returned more than 2,700%.
Diversification is supposed to go beyond not putting all of your eggs in one basket as far as industries or types of assets. It also should be geographical. On that latter measure, though, investors have gone with what has worked in practice, not what they should have done in theory. Since 2016, U.S-based funds that invest in Western Europe have seen large net outflows—amounting to around $50 billion, fund tracker EPFR Global says—as Americans lost faith in the world’s other big developed market.
The average investment adviser in the U.S. allocates only 22% of funds to international equities, when these make up 40% of the MSCI World Index, data by asset manager Janus Henderson show.
Even then, research suggests that Americans’ “home bias” in equities remains somewhat smaller than in other countries, and has been falling over the long term.
Ironically, the period in which U.S. stock markets have more starkly left the rest of the world far behind has been since the 2008 financial crisis—a crash that originated in the American shadow-banking system and credit derivatives built on top of U.S. residential mortgages.
One of the biggest questions investors must ask themselves now is whether the 2020s will confirm or undo the trend. The dollar is a key part of the answer.
A big chunk of the extra returns that U.S. investors have gotten at home is explained by the greenback, which has gained 23% against a basket of other currencies since 2010. This was driven by faster economic growth in the U.S. relative to the rest of the world, which allowed the Federal Reserve to start nudging up interest rates even as other major central banks were stuck pegging them at record-low levels. Higher rates tend to attract even more funds into the country.
This past year was a crucial test of whether America’s outperformance was coming to an end as the trade spat with China fueled fears of a U.S. recession after the longest period of expansion on record, creating volatility in the stock market and leading the Federal Reserve to start cutting rates again.
But such expectations were wildly misplaced. Europe and Asia are more dependent on trade, and therefore more affected by global economic slowdowns, than the U.S. Furthermore, market turbulence tends to push money into safer assets, and the dollar is usually at the top of the list.
Now that economic data is improving, though, many analysts are eyeing 2020 as the year in which moving money overseas will once again prove wise. Both the trade negotiations and Brexit now appear closer to a resolution and political turmoil in the eurozone appears to be abating. By contrast, the U.S. could prove rocky for traders given that there is a presidential election on the horizon.
Investors, however, should be skeptical of the idea that the decadelong trends that have favored the U.S. are about to turn.
There are structural reasons for why American companies have done so well since 2010: Their return on equity—a measure of how efficient they are at generating profitable investments—has improved, widening the gap relative to firms in Europe, where it has fallen relative to before the crisis. This suggests that U.S. companies operate in lines of business with more growth potential.
On the face of it, this shouldn’t be surprising: The big corporate story of the last decade has been the rise and consolidation of tech giants like Google (GOOG) and Facebook (FB), all of which are U.S. companies. Data confirms that the biggest gaps in return on equity between the two regions have opened up in big companies, and more specifically in the technology and consumer discretionary sectors—a category that includes Amazon.com (AMZN).
This is visible in other market dynamics. Historically, stocks that trade cheaply relative to their earnings—so-called value stocks—have tended to outperform over the long term. But over the past decade, value-stock pickers have been hammered in favor of those who bet on “growth” firms. These trade at expensive levels relative to earnings because they are expanding aggressively but have business models with the potential to generate outsize returns once they reach a critical size.
Until 2012, analysts and investors still looked at such promises with some reluctance. But Amazon then started boosting its gross profit margins at an accelerated pace, proving that tech giants had indeed unleashed a new era in which adding digital users multiplies the gains from economies of scale and network.
These firms also get a big chunk of their revenues from the rest of the world, allowing shareholders to get international exposure through other means.
While the recent implosion of tech unicorns like WeWork cast a small shadow on this story, the U.S. remains the dominant presence in the new digital economy, while Europe relies on the likes of banks and car manufacturers, and Japan’s technology firms remain overly focused on electric machinery.
The notion that the U.S. is fundamentally “exceptional” relative to other countries has always been politically controversial. In financial markets, though, investors may want to keep going with what has worked.
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