US stock market exceptionalism

Published in The Sunday Times on 19th January 2025.

The prevalence of positive illusions is one of the most well-established findings in psychology. Most people have an exaggerated view of their own abilities and expect that more good things—and fewer bad things—will happen to them than is likely. On average, we tend to think that things are likely to improve in the future – a quirk which has some basis in evolution - as the optimists out-reproduced the pessimists. 

I can’t help but think that this bias is evident in attitudes towards US financial markets. The notion that the US is unique, and uniquely superior, as regards its financial markets is now a well-established phenomenon. And in fairness, it is an idea that is well supported by evidence. 

US Exceptionalism

2024 was another year of strong double digit returns for the US stock market. The S&P 500 returned 25% in USD terms, compared to just over 5% for global markets excluding the US. Since 2010, a dollar invested in the US has accumulated to $7 today, versus just $2.30 for global ex-US.

And this isn’t just a 21st Century phenomenon. Over the 1900–2020 period, the annualised real (inflation-adjusted) return on US equities was 6.6%, which contrasts with 4.5% real USD return on a 90-country index of international, non-US equities over the same 121-year period. The US has been an exception - essentially forever. 

The pre-eminence of US equity markets has been supported by an extraordinary return on capital, fostered by a very favourable regulatory environment. According to Bridgewater Associates, the outperformance of the US in the last decade was driven by a combination of faster revenue growth, bigger margin expansion, and rising P/E (price to earnings) multiples - in roughly equal proportion. The returns for an unhedged global investor have been further enhanced by the stronger US dollar over the period. 

The US economy continues to hum. The US working age population is forecast to increase while others shrink, supporting long-term US economic growth. The Artificial Intelligence (AI) theme, which disproportionately accrues to US tech companies should improve productivity for US companies across a variety of industries helping to keep wages and consumption high.  

What could threaten the US?

And so the search for compelling reasons for the end of US exceptionalism runs cold very quickly. Valuation is certainly the strongest counterargument to the US evangelists. The S&P 500 12M forward P/E is above the 90th percentile going into 2025, and the valuation challenge is no longer just about mega cap tech – US stocks excluding the so-called ‘Magnificent Seven’ have also reached the 90th percentile. 

America’s debt problem is big. Debt-to-GDP is forecast to exceed 100% this year. And growing; the US’ deficit, as a share of GDP, is set to hit 6%, dwarfing the European Union’s mandated 3% limit.

But many of these same arguments could have been made, to varying degrees, at any point in the past few years. The US being expensive is not a new thing, so we should be humble about its predictive value in signalling the end. And it seems the upper limit on debt that typically applies is more impotent when it comes to the issuer of the reserve currency of the world.

So, I am optimistic about the case for US equities. 

Where’s the but?

There has to be a 'but' — and it’s this: there comes a point when you have to question how much you are comfortable investing to back that view. It seems as though the financial world is increasingly unipolar. The booming US market is sucking money out of the other markets. The US stock market now represents over 70% of the market capitalisation of worldwide equities. And because the US market itself is top-heavy (through the Mag-7) a passive allocation to global equities would mean that seven stocks make up a bigger weight in a portfolio than the next seven biggest countries combined.

None of the above reasons in favour of continued US exceptionalism are secret. Strong US Earnings Per Share growth outperformance is already in the price, at a time when many of the largest drivers of backward-looking US equity outperformance cannot be counted on to repeat going forward (from tax cuts to globalisation, to the incredible fiscal support for corporate profits and of course, multiple expansion). 

Maybe AI will surprise to the upside in terms of unleashing a broad productivity impact across sectors that is not currently priced in. But the bar for continued outperformance seems very high at this point.

Exceptionalism didn’t happen in a straight line 

Can US stock markets dominate indefinitely? I’d be willing to wager a lot of money that the answer to that question is “No” (eventually).

Cliff Asness, a prominent hedge fund manager wrote a piece in the last week where he projects himself forward to 2035 and looks back at the decade just gone (coming). If I had the luxury of ignoring markets for the next ten years, I’d find his assessment compelling.

“It turns out that investing in US equities at a CAPE* in the high 30s yet again turned out to be a disappointing exercise….despite continued strong earnings growth, US equities only beat cash by a couple of percent per annum over the whole decade...” That’s a scary prospect. Last month’s Global Fund Manager Survey revealed the 4th largest overweight of US relative to European equities since 2001. Too many people with positive illusions would be heavily scarred if Asness is proved right.

*Cyclically Adjusted Price Earnings ratio.
  

Source: Data is sourced from Bloomberg as at market close 31st December, returns are based on total indices in local currency terms, unless otherwise stated.

Gary Connolly is Investment Director at Davy. He can be contacted at gary.connolly@davy.ie or on X at @gconno1.