Okay, here’s a quick puzzle for all of us who have a 401 (k) or other retirement portfolio. As we all know, the American funds in our wallets have been hitting the pants of international funds, and have been for months, years and more than a decade. In the past five years, for example, US equity index funds such as the SPDR S&P 500 ETF SPY, + 0.13% and the Vanguard Total Stock Market Index Fund VTSMX, + 0.01% have generated about twice the return. total of internationally oriented equivalents. , such as the EFA iShares MSCI EAFE ETF (Europe, Australasia and Far East), + 0.27% or the Vanguard Total International Stock Index VGTSX fund, -0.24%.
If you go back to the beginning of 2010, US funds outperformed 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. Why? That is all. Why have US equity funds fared so much better than international equity funds? That’s the challenge hedge fund leader Cliff Asness faces in a remarkable new analysis with the brilliant title “The Long Run Is Lying To You.” And what he finds helps improve much of what is considered conventional wisdom, on Wall Street and Main Street, about our retirement accounts. If you think US funds have done much better because US companies have produced more earnings per share and faster growth than their international counterparts, think again, Asness reports. If you think American companies have generated higher, faster-growing dividends, that’s a failure, too, Asness reports. Actually, using data dating back to 1980, it shows that the earnings and dividends of US and international stocks (and funds) have been in line. The underlying superior performance of US companies, as is, explains a small fraction of their better returns. The real explanation? Price. From 1980 to 2020, “We see a giant price change with the United States becoming relatively much more expensive” compared to the rest of the world, Asness writes. Investors are simply willing to pay much more for every dollar of US earnings compared to the earnings of international companies. He illustrates this using one of the stock market’s favorite criteria, the so-called cyclically adjusted price-earnings ratio, which compares the price of a stock to the company’s net income for the previous 10 years. In 1980, the US and international stock indices were trading for roughly the same CAPE, Asness reports. Today, the CAPE in the US market is double the international average. This change is gigantic and in addition to any change in earnings itself. It‘s not so much that US earnings have risen much more than international earnings, it is that US stock prices have risen much more, relative to their earnings, than international stock prices. Over the period 1980-2020, this “valuation shift” has accounted for about 80% of the total US outperformance, Asness reports. And as of 1990, a happy period for US stocks due to the collapse of the Japanese bubble, it still works at around 75%. In other words, US stocks have not become more popular because they have performed so well: They have performed so well because they have become more popular. All investors are raising the price of US stocks because we believe they are “better”, and by raising 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 puzzled by the previous riddle, this is an opportunity to repeat it. Just as US stock funds have outperformed international stock funds in our portfolios, exciting go-go “growth” funds have outperformed boring “value” funds. (“Growth” funds invest in tomorrow’s (expensive, but fast growing) companies like Tesla TSLA, -0.63%, while “value” funds invest in (cheap, but slower growing) companies Today and yesterday as Ford F, -1.16%.) Since the beginning of 2010, for example, the Vanguard Growth VUG ETF, + 0.35% has generated returns 75% higher than the Vanguard Value VTV ETF, -0.06 %. In the last five years, growth has outpaced value by a clear 100%. But, once again: Why? Why have growth funds been a much better investment than value funds? Asness runs the numbers and finds the same answer. It is not due to relative earnings growth or dividend payments. Again, he says, it’s for the price. This time he uses another popular yardstick, comparing stock prices to the value of a company’s net assets. From 1950 to about 1990, he calculates, US “growth” stocks averaged four times as expensive as value stocks by this measure. Today? They are 10 times more expensive on average. That gap is as wide as it was during the 1999-2000 dotcom bubble, he says. In other words, it is the same paradox or illusion. We believe that “growth” stocks have become more popular because they have performed very well. But actually, the main reason they have performed so well is that they have become more popular. The investment fashion for growth stocks is not so much the reflection of their superior performance as the cause. We pay more and more for the privilege of investing in the hopes and dreams of tomorrow. What this means is that if we expect US stocks and growth stocks to continue to perform as well in the future as they have in the past, we have to accept heroic assumptions. Not only do they have to stay fashionable, they have to be even more fashionable. And heaven forbid if they really go out of style. Fortunately, fashion does not cycle, and what is popular today will undoubtedly be tomorrow. Ask any young man.