Mean Reversion?
The last two years have delivered exceptional returns for stock investors. U.S. large-cap stocks in particular have returned over 20% each year, the first time since the late 1990s. Looking further back, U.S. stocks have returned 16% on average versus 9% for their international counterparts since the global financial crisis.
The U.S.’s dominance is directly attributable to a few large technology companies. “Magnificent 7” stocks - Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta, and Tesla - account for almost half of the S&P 500’s return in the latest bull market beginning October of 2022. As large tech companies go, so goes the U.S. stock market.
The sheer scale of today’s largest tech companies has grown to the point where they now comprise a third of the S&P 500 index. This level of concentration has elevated the risk associated with the U.S. stock market, underscoring the importance of prudent risk management through diversification. An allocation to international developed and emerging stocks offers a broader diversification framework to help mitigate the risks associated with overexposure to a country, economic sector, and company.
The Cyclical Nature of Outperformance
Historically U.S. and international stocks outperform in cycles of 5-10 years, with one outperforming the other during different economic and market regimes. U.S. stocks have significantly outperformed the last 16 years or so because of robust economic growth, superior technological innovation, and solid corporate profitability relative to the rest of the world. But, there have been times in history when this wasn’t the case.
A look back at the “lost decade” beginning in 2000 serves as a recent reminder that U.S. stocks haven’t always dominated their international counterparts. Emerging economy stocks returned 154% while U.S. large-cap stocks declined -9%. A combination of rapid economic growth, a boom in commodity prices, and favorable demographic trends benefitted emerging stocks.
In the 1980s, Japan was the dominate force in the global stock market. At its peak, Japan accounted for 45% of the world stock market’s value (today it accounts for 5%). The Japanese stock market experienced an 11 year bull market, as the Nikkei 225 index soared nearly tenfold. Ultimately, the Japanese stock market crashed and kickstarted the U.S’s outperformance cycle in the lead up to the dot-com bubble.
A closer examination of U.S. market leadership reveals two distinct periods of dominance: the 1990s and the present day. Both eras share a common catalyst - the meteoric rise of technology stocks. Unlike international markets, which are more heavily weighted toward cyclical industries, the U.S. stock market has been uniquely driven by innovation and advancement of tech companies.
The cyclical nature of outperformance can be explained by mean reversion - the tendency for asset prices, returns, and valuation metrics to revert to their historical averages after periods of excessive gains or losses. When investments generate above-average returns, they eventually moderate as competition intensifies and valuations become stretched. History shows that investors often overestimate long-term success, driving prices higher than fundamentals justify, only for the market to correct over time.
U.S. and International Stocks Today
The United States now makes up 67% of the MSCI All-World Country Index, while accounting for a fourth of global GDP. A hint that valuations may be stretched. U.S. tech companies trade at 28x their forward earnings (the 20-year average is 12x forward earnings). We continue to advocate for a healthy allocation to U.S. stocks given their leadership in AI development/deployment and technological innovation, but the risk-reward relationship has shifted amid lofty valuations.
Last month, Chinese artificial intelligence (AI) company Deepseek challenged the true cost of creating sophisticated AI models. Bested only by OpenAI’s ChatGPT 4.0 and Google Gemini in certain AI rankings, Deepseek is built with techniques that are 95% to 97% cheaper than their rivals according to their published technical papers. Is this a Sputnik moment for AI? Ultimately competition is good for users, but this is an example of the headwind U.S. technology companies face as lofty valuations are challenged.
Companies domiciled internationally such as Novo Nordisk, Toyota, AstraZeneca, LVMH, and Taiwan Semiconductor provide exposure to innovative technology and prevailing market themes at more compelling valuations. All eleven economic sectors in the international stock market are trading at historic valuation discounts (much lower than the 20-year average) to their U.S. peers. At present, international stocks are trading at 14x forward earnings versus 22x for the S&P 500 – two standard deviations below the historical discount average.
From a diversification standpoint, international stocks are more oriented toward cyclical economic sectors. For example, the French and Japanese stock markets are largely driven by industrial, consumer discretion and financial stocks. While Britian’s stock market is driven by financial and consumer staple stocks. This balances U.S. stock concentration in growth-oriented sectors such as info tech and communication services.
More simply put, stocks in different countries behave differently. Economic and market forces unique to a specific country have greater influence on that country’s stocks than events happening outside that country’s borders. These differing influences produce returns that can vary from those of an investor’s home country.
Many global central banks such as the Bank of England, European Central Bank, and the People’s Bank of China are expected to continue interest rate cuts to spur economic growth. Future projections indicate that much of the real GDP growth will occur outside of the United States in areas such as India, Saudi Arabia, and Indonesia. Emerging economies are projected to grow at twice the rate as the United States this year.
Interestingly, European stocks would have outperformed the S&P 500 over the past two years if only NVIDIA was excluded. Looking back over the past 10 years, the JSE Market Index (South Africa) and Taiwan Taiex Index have outperformed the U.S. In fact, the S&P 500 has not been the best performing individual stock index in any of the past 16 years. To date, German and French stocks have returned 9% and 8% respectively in dollar terms, outpacing the S&P 500’s 3% return.
What It All Means
The core objective of international diversification is to enhance risk management by reducing reliance on any single economic sector, country, or company. For stock investors, one of the greatest risks is the potential for significant losses due to overconcentration. Historically, a well-balanced portfolio of U.S. and international stocks has helped mitigate these risks, promoting more stable returns over time.
Looking ahead, the trajectory of market outperformance will be shaped largely by the continued dominance of large U.S. technology companies relative to their global counterparts. However, history has shown that no market leader remains on top indefinitely. Against this backdrop, international diversification appears increasingly prudent, offering a broader opportunity set at attractive valuations and a hedge against excessive concentration in U.S. stocks.
Beyond company and sector dynamics, global stock markets face the persistent uncertainty of trade tensions. The new administration has signaled its willingness to impose new tariffs on key trading partners, a move that could fuel inflation and constrain global economic growth. At present, these tariff threats appear to be a negotiating strategy, aimed at bringing major trade partners to the bargaining table rather than a definitive policy shift.
We anticipate continued market volatility as investors digest new developments. However, instead of reacting to short-term uncertainty, we encourage investors to stay disciplined and remain aligned with their long-term financial plans. Our investment strategies are intentionally designed to navigate market fluctuations and withstand periods of heightened uncertainty, ensuring resilience through economic cycles.
Contact us at 865-584-1850 or info@proffittgoodson.com
DISCLOSURES: The information provided in this letter is for general informational purposes only and should not be considered an individualized recommendation of any particular security, strategy, or investment product, and should not be construed as investment, legal, or tax advice. Proffitt & Goodson, Inc. makes no warranties with regard to the information or results obtained by third parties and its use and disclaims any liability arising out of, or reliance on the information. The information is subject to change and, although based on information that Proffitt & Goodson, Inc. considers reliable, it is not guaranteed as to accuracy or completeness. Source information is obtained from independent financial data suppliers (Interactive Data Corporation, Morningstar, etc.). The Market Categories illustrated in this Financial Market Summary are indexes of specific equity, fixed income, or other categories. An index reflects the underlying securities in a particular selection of securities picked due to a particular type of investment. These indexes account for the reinvestment of dividends and other income but do not account for any transaction, custody, tax, or management fees encountered in real life. To that extent, these index numbers are artificial and cannot be duplicated in real life due to the necessity of paying those transaction, custody, tax, and management fees. Industry and specific sector returns (technology, utilities, etc.) do not account for the reinvestment of dividends or other income. Future events will cause these historical rates of return to be different in the future with the potential for loss as well as profit. Specific indexes may change their definition of particular security types included over time. These indexes reflect investments for a limited period of time and do not reflect performance in different economic or market cycles and are not intended to reflect the actual outcomes of any client of Proffitt & Goodson, Inc. Past performance does not guarantee future results.
