Do We Really Want to Stay Overweight U.S. Stocks?
And you thought we would be writing about the election? We place a high value on both our limbs and on the friendships that we have forged over years and decades with clients. We do have plenty of data and plenty of opinions, but you really need to put in some hard work to pry the opinions out of us. Besides, surely you have seen the charts that show how the stock market fares given the makeup of the White House and Congress…it’s actually pretty good in all circumstances, slightly better for Democratic presidents than Republicans, better for Republican Congressional control than Democratic, but balanced government beats unbalanced.
Now if you really want to talk about performance difference makers, the obvious starting point would be U.S. versus international stocks. In case you were skeptical about this, please tell me how you feel about the performance of each over the last 16+ years:
From 2008-2024, we endured the following: a financial crisis (which the U.S. essentially caused), a decade of Fed-induced financial repression and moribund GDP growth, covid, the worst inflation since the 1970s, and the resultant panic attack in both the stock and bond markets in 2022. Yet, U.S. stocks have nearly quadrupled in that time, returning an average of 10.5% annually, including dividends.
International stocks have not even gone up during this same period. They have paid dividends, so annual return comes to +3.2%. But still, that’s a big enough gap that you could drive Jeff Bezos’ yacht through it.
If you’ve seen this chart before, likely it accompanied this story: “While we’re grateful for having portfolios almost entirely in U.S. stocks, it makes us question how far the proverbial rubber band is stretched, and whether (or when) it might snap; but there’s some pretty good reasons why the U.S., despite its manyissues, is still justified in reigning supreme. Depending on your perspective, we’re either still dominating the world or we’re the best house in a bad neighborhood.” That powerful back-and-forth conversation is then followed up with exactly no portfolio realignment.
We need to state upfront that we have always, consistently, said that we get international exposure vis a vis the companies in which we invest. Our core stocks derive over 40% of their sales from markets outside the U.S. We let our companies decide where to deploy capital; they know better where they can expect to derive the most growth and profitability. Geographic diversification theoretically reduces risk of operating in one single market, if something unusually bad were to happen to the U.S. economy.
These are still relevant arguments, especially if you believe the U.S. has intrinsic competitive advantages that give its own companies a leg up against international peers, even on foreign turf. For example, you could say that having such a huge, homogeneous home market gives American companies a scale advantage. In tech, Microsoft, Amazon, and Google have dominated cloud computing, rather than European or Asian Big Tech, partly because they have had better access to a better supporting technology ecosystem in the U.S. The U.S. has a thriving VC (venture capital) industry, investors willing to risk vastly more money, and startups to be acquired for their newer technologies and entrepreneurs. Med tech and Big Pharma in the U.S. have a leg up because there is far more money invested into R&D here, and because the U.S. doesn’t (yet) have single-payer healthcare, which would radically limit profit potential and thus innovation. Finally, regulators are generally kinder in the U.S. than in socialist countries, which enables companies to pursue innovation, growth, and capital spending, which produces future growth. The U.S. is quickly “catching up” to Europe in the last 3.5 years (see: FTC, DOJ, EPA, DOE, and especially the SEC), but for now we are still the best house in a bad neighborhood.
You might be so persuaded by now that the U.S. will keep on kicking butt that we can just close the book on this and move on to the election, since I have 4 more pages to ramble on. We’ve got the performance evidence and the narrative to go with it. Why go farther?
But what if much of the 290% excess performance of U.S. stocks over international stocks can be attributed to valuation? Did U.S. stocks become way more expensive, and international stocks not? It is true that American investors have been sellers of international stocks as they continue to underperform and global investors have plowed into U.S. stocks. But if earnings growth has been superior for American companies, and that explains most of the excess performance, should we give investors a break and allow them to love U.S. stocks a little more? For the answers, read on.
Some of you might be wondering why we’re even talking about international stocks, and that’s a good question. If you’ve been blissfully owning great American stocks and seeing your portfolio value climb and climb since 2008, we’ve trained you well. You’re keeping the main thing the main thing…own great companies and hold them forever. Those of us in the business must always keep some eye on the investing world around us, if only to understand what other people are doing and why.
Let’s flash back to the 1990s. Just as in the 2010s, stock market performance was dominated by the U.S. Then came the dot.com crash of 2000-02. As always, the financial services industry did not let a stock market crash go to waste. These are always prime opportunities to sell investors alternatives to what just crashed, even as they skirt the obvious reality that you can’t go back in time and sell what crashed before it crashes and buy what didn’t. Nonetheless, scars can run deep for some investors, and they vow to “not go through that again.”
Huge mutual fund colossi will remind you that the more asset classes you own, the less you would get hurt by one asset class crashing. Obviously, that’s true. Bonds are the natural, tried-and-true diversifier for stocks, and we have always used bonds for this purpose. But, the asset management industry has routinely rolled out more and more asset classes that should also be used to mollify that downside risk. In the 2000s, it was international stocks (and commodities). Investors plowed money into them after 2002, because scars from the U.S. crash were deep, and fresh. Never mind that international stocks did no better than U.S. stocks in the 2000-02 crash, and earnings fell harder.
Before we dive into the charts, how are developed and emerging markets defined? The distinction is on a few fronts: how grown up are their institutions, has inflation been in control, how much influence resides in the private sector, and (most importantly) how big is their GDP per capita (the size of the economy per person). Developed markets include the U.S., Canada, Western Europe, Japan, Australia, New Zealand, and Singapore. Emerging markets are predominantly in Asia, Latin America, Eastern Europe, plus Egypt and South Africa. Most of Africa is considered “frontier markets,” which are even less developed than emerging markets. On the straddling line between emerging and developed would be South Korea, Israel, and perhaps the oil-rich Arab economies. The Arabian Peninsula countries have high GDP per capita, but not much of a private sector, as their governments control most of their economies.
So, did all that heavy lifting by the mutual fund industry work? Yes. Developed international stocks (blue line) outperformed the U.S. (black) by roughly 75% from 2002-07, and emerging markets (green) crushed them both:
But, was it deserved, by virtue of better earnings growth? A little. International stocks slightly outgrew their American counterparts, and emerging markets did even better. You will see that developed markets’ earnings fell harder in 2000-02 than U.S. earnings, which hardly fell. Emerging markets’ earnings didn’t fall. Then both developed and emerging markets enjoyed better growth from 2002-07:
It’s worth pointing out that this was the golden era for China and other emerging markets, as the world outsourced production to them throughout this decade, which pumped up their economies and also pumped-up commodity prices to account for the global production realignment and increased trade. Europe was far more levered to this cyclical boom than the U.S.
The clothes of the diversification emperor, however, were exposed as a façade in the financial crisis of 2008. International stocks were supposed to protect downside from the exact scenario that occurred—an exogenous, country-specific (U.S.) economic calamity—but instead actually underperformed their American counterparts during the financial crisis. Then a year after the financial crisis ended, the Eurozone crisis began, when countries that probably shouldn’t have been let into the common euro currency (Greece) essentially went bankrupt until the rest of the EU begrudgingly decided to backstop them all. Remember the PIIGS (Portugal, Ireland, Italy, Greece, Spain)?
The result was a European economic hangover that lasted for most of the 2010s, as the ripple effects traveled through the European banking system and ended up in the consumer’s lap. Population growth slowed to 0, inflation was nearly 0, and thus economic growth was not far from 0. Europe and Japan competed to see how far below zero they could push their central bank borrowing rates, to stimulate their moribund economies. Looking back, most economists believe the net effect of sub-0 central bank interest rates actually served to UNSTIMULATE, rather than stimulate. The punishment of savers and pensioners (who double as consumers) offset the benefit to borrowers, because there was hardly anyone looking to borrow to expand. This gave rise to the maxim in the 2010s that the U.S. was the best house in a bad neighborhood (U.S. growth was slow, but not as bad as Europe’s).
Which brings us to China. The world’s second largest economy ranks 69th in the world in GDP per capita, just behind Malaysia, St Lucia, and Kazakhstan. On that basis alone, China is still an emerging market. The influence of the CCP (Chinese Communist Party) is another reason. The Chinese stock market is home to a very large market of publicly traded stocks, most which can be owned by international investors, so it would seem that capitalism is alive and well in China. Freedom is not abundant in China, but people are free to choose a career, decide where to go to college, decide whether to marry and have kids (or not, a sore subject these days), start a business, expand the business, get external funding for it, list it on the local stock exchange….sounds like capitalism to us.
China was still a very poor country in the 1980s, and decided that by opening up their economy, if only a little, to outsiders, they could convince the world to adopt China as their outsourced manufacturing center. This would create better jobs, give consumers more money (paid by other countries), stanch the flow of people leaving the country for greener pastures, and ultimately achieve the CCP’s goal of dethroning the U.S. as the superpower of the world. It actually worked…well, almost.
At first, it worked too well. The creation of so many better-paying jobs fueled the desire for the spoils of a better life, and with intense competitive desire to work their way up the corporate ladder, they stopped having kids. The CCP eliminated the one-child rule 15-20 years too late, in 2016. There are 35 million more males than females in China, also a result of the one-child rule. China’s population has already peaked and is slowly declining. But also, life span of the Chinese increased so much that their bulge of retirees is suddenly exponentially larger, which will eventually strain the government.
China was rolling along and actually skated through the 2008-09 financial crisis relatively intact, as more and more companies moved production offshore, as a means to cut costs, because profits were falling fast. But just to be sure, the CCP decided to double-down on stimulus. They freed up trillions of yuan to develop the infrastructure that would be needed to accompany the country’s imminent next phase of growth. The largest amount of spending would be on residential construction to house the tens (hundreds?) of millions of rural dwellers that would move to the cities to snag all those job openings.
But, it eventually stopped working. Whether because of the CCP’s interrogation of foreign business leaders, the omnipresent monitoring of everything everyone does, the poor treatment of people in Xinjiang and Hong Kong, the belligerence and animosity aimed at other countries (i.e. their customers), or probably 20 other reasons, businesses have more-or-less stopped moving production to China, and a very large contingent have moved out to friendlier countries that also happen to be cheaper (Vietnam) or closer to home (Mexico, Eastern Europe). Jobs have stopped growing, unemployment is rising (youth unemployment is reportedly as high as 46%), property prices are falling, consumer confidence is in the gutter, so consumers are saving more and consuming less.
Even worse, trillions poured into real estate now sit empty. A former official of the country’s Statistics Bureau is on record stating the number of empty dwellings in China could hold China’s entire population. Now, unoccupied is not the same as unsold; many Chinese have acquired 3, 4, or 5 apartments as investments, because prices could only go up. Sound familiar? With prices in some markets -20% from their peak, many are likely upside down now. Many unsold units have been acquired by State-Owned Enterprises, on direction from the CCP to not make the housing inventory seem as bad. Suffice it to say, construction is on the precipice of collapsing, and this has been a huge part of their economy.
As crazy as China’s current situation is, at least you could look back on the heady growth days of 1995-2020 and find robust growth in earnings, right? The answer is a resounding no:
Earnings for China’s MSCI index of companies were around $5 per share in 1996 and are now around $6 per share. 20% growth in 28 years. Meanwhile, its economy expanded 2,200%. How exactly did Chinese companies snatch defeat from the jaws of victory? The answer isn’t totally clear-cut, but a good starting point is always to assess supply and demand. Demand has obviously grown exponentially, for everything. It appears, however, that supply has grown even faster in the aggregate.
There is no official statistic for aggregate supply, but you can see it all around in China. They figured a long time ago that they would need a lot of steel to pull off their audacious plans. To obtain all this steel, they created steel producers, exponentially expanded capacity to make steel, signed agreements all over the world to source iron ore, even helping to fund the massive infrastructure needed in Western Australia to mine the ore and to export it. China now produces 53% of the world’s steel and consumes most of it. But there are times when they produce too much and try to export it at cheap prices to anyone who will buy it. Unfortunately, most of the world has enacted tariffs to protect their homegrown steel industry. Inevitably, it gets sold at a loss, whether at a low price or with a high tariff.
China uses the same playbook for everything, including its latest endeavor, EVs (electric vehicles). After “obtaining” the technology from other countries, they created production capacity as fast as possible. China now produces, by far, the most EVs in the world. EV adoption by Chinese consumers has been rapid, but they produce far more than they need inside China, which is intentional because they want to dominate the world. As with steel, many countries (with homegrown automakers) have swiftly slapped tariffs on Chinese autos to protect their own auto industries. The problem is that supply seems to be uncontrolled. Pictures surfaced last year of humongous fields in China that were filled with thousands upon thousands of junked EVs, there because they couldn’t sell fast enough.
One stock we have followed for awhile is YUM China, the spinoff from YUM 10 years ago of KFC, Pizza Hut, and Taco Bell stores in China. KFC has proven to be very popular in China and has consistently grown, primarily by slapping up new stores. Earnings have indeed grown over time and there is much to like about YUM China, in particular that it is the only national chain to own its own sourcing and distribution infrastructure, fantastic management, and that new stores are really easy and really cheap to open; they are much smaller than in the U.S. The “T” in the SWOT (Strengths, Weaknesses, Opportunities, and Threats) analysis, though, is unlimited competition. Every fast-food chain is rapidly building new stores. Tastien, a local competitor, increased its store count in China from 3,200 to 6,700….in 2023 alone.
We could go on and on, but you surely get the point that all this production, all this oversupply, absolutely wrecks profitability. The phrase “winning at all costs” is literal in China. Plus, government regulation is better termed “interference” in China’s private sector. In the eyes of the CCP, they exist for the state’s purposes. Investors are no dummies; they know that profitability and profit growth determine a stock’s value. Chinese stocks have lost 16% in total since 2007. So, what about the rest of the world?
As you can see, the black line shows how earnings of American companies have risen ~150% since 2007, before the financial crisis. EAFE earnings have not risen. Emerging market earnings rose strongly in 2010-11 as commodity prices recovered, but likewise have not grown in 17 years. Emerging market earnings dropped and have continued to drop since then. So, valuation explains some of the outperformance of the U.S., but less than half.
Will this continue to be the case? Is Europe a “dead continent” as far as their economy goes? They have a LOT of things going against them: 1) they’re old countries, with traditional mindset and antiquated production; 2) governments have a heavier hand in determining outcomes; 3) declining population, especially now that failed immigration policies are being retraced; 4) proximity to belligerent actors like Russia and the Middle East; 5) reliance on China as an export market; 6) vastly higher natural gas and electricity prices than in the U.S. because they are no longer energy-independent and have moved too quickly to renewable energy; and 7) only 10% of structures in Europe have A/C (versus 90% in the U.S.). If the world de-globalizes, this will be very bad for a lot of countries in the world and Europe won’t fare well, though they will adapt and make do. The U.S., however, is vastly more independent already and has so many entrenched advantages. We just need to not fritter them away.
Speaking of frittering away our advantages, the election is coming up! While we committed to deep analysis and high-conviction predictions, unfortunately we have run out of space in the newsletter… But seriously, we have a slew of charts that are very intriguing, and we are happy to share them with you. Let us know if you are interested.
