A few months ago I had a debate with a prominent Australian economist who said that given the performance of US shares versus Emerging Markets over the past 15 years that super funds and investors would be silly to bet against that trend continuing.
I took issue with it because I thought it was a little naïve to base predictions for the future on what’s happened over a relatively short timeframe of 15 years. And it was a timeframe where US shares had performed spectacularly and Emerging Markets less so, dragged down by China whose economy had experienced recessionary-like conditions for several years.
This economist’s views though have been echoed by investors in Australia. Most of the major super funds are continuing to pour money into the US, and individual investors are too.
In August, international share ETFs in Australia received the highest flow of funds with $2.4 billion, followed by fixed income ($1.2 billion) and Australian equities ($823 million).
It’s part of a longer trend of money going into international equities. And given US stocks are around two-thirds of global indices, most of the funds are being invested in America.
Source: Betashares
It’s not just Australian investors who are betting on US shares either. American investors themselves are seemingly all in.
Zooming out on returns
Some of you may be surprised by my comment that 15 years is too short a timeframe to judge returns. I like to look at performance over many decades as it provides more context for current markets and what may happen in future.
Yet even over the long term, US market returns stand out.
Total returns per annum in AUD
Source: Vanguard, Firstlinks
Since 1970, the S&P 500 has returned 12.3%, international shares 11% and Australian shares 9.7%. $10,000 invested in US shares in 1970 would be turned into $5.7 million, for international shares it would have turned into $2.3 million, and for Australian shares it would have turned into $1.7 million.
It’s amazing how relatively small differences in annual returns result in large discrepancies in total returns. That’s the power of compounding!
Another thing to note from the chart is how good US returns have been since 2010. Both the last decade and this one have produced returns of 16% per annum. That’s way above the annual return of close to 10% over the past century.
It’s also apparent how volatile US market returns are. The 1970s were poor, especially when adjusted to high inflation. In fact, cash easily topped equities during that period.
Yet the 1980s and 1990s saw amazing returns for stocks, especially in the US. Then that was followed by an awful decade in the 2000s which delivered negative annual returns from US shares, thanks to the internet bust and 2008 financial crisis.
In comparison, Australian share returns have been less volatile. This decade’s 9.7% annual returns are slightly below the 10.4% recorded since 1900, yet they’re still reasonable.
Overall, however, US shares have been stand-outs when it comes to performance since 1970.
The big question is: will it continue?
What’s interesting this year is that for all the hoopla over AI and the Magnificent Seven, US shares have badly trailed international shares and emerging market shares. So, emerging market stocks are up 19% in USD terms year-to-date (YTD), helped by a 34% return from China. That compares to YTD returns from the US of 11%. Australian shares too have outperformed America both in local currency and USD terms this year.
Drivers of US returns
To assess whether past US returns are sustainable going forward, let’s dig into the key drivers of returns. Namely, earnings and valuation multiples.
On earnings, S&P 500 forecast EPS growth is 9% this year, followed by 14% in 2026 and 12% in 2027. That’s well above the average of 7.3% since 2001.
What’s fascinating is that revenue growth is expected to slow this year, yet margin improvement is predicted to contribute more than half to total EPS growth.
Higher margins aren’t just a this year story. US margins have more than doubled since the 1990s.
It’s been driven by many trends, including the rise of high-margin tech behemoths, including the Magnificent Seven.
Source: Ritholtz Wealth Management
The other big factor in stellar US performance has been an expansion in valuation multiples attached to the market. Bottoming at 10.4x price-to-earnings (P/E) in early 2009, the S&P 500 is now trading at a forward P/E ratio of 22.
US market prices look extended no matter which valuation method you use.
Source: JP Morgan Asset Management
When valuations are this steep, it normally doesn’t augur well for future returns, especially over longer timeframes.
Source: JP Morgan Asset Management
Even assuming a relatively benign outcome of flat margins and P/E ratios would mean US returns of low-to-mid-single digits over the next 5-10 years. It would need a sustained boom in earnings, perhaps led by AI, to prevent that from happening.
How the rest of the world looks
Believe it or not, while US earnings have been great, they’ve trailed the likes of India and Japan this decade. And while Europe and China earnings haven’t been healthy, they’re also forecast to pick up over the next year.
Source: JP Morgan Asset Management
And the price that investors are paying for earnings in the world ex-US are much cheaper. Japan and China especially appear inexpensive.
Source: JP Morgan Asset Management
What about Australia?
Australia is a different case. 2025 is expected to be the third year in a row where the ASX 200 delivers negative earnings growth. The poor record has been driven by pedestrian profits from the banks (is it any wonder why they are now on a cost cutting exercise?) and mining earnings falling sharply due to commodity prices retreating.
The consensus forecast is for earnings to increase by 4.5% next year, though this number can’t be trusted as stockbrokers are always too bullish on their profit forecasts.
The amazing thing is that the earnings drought hasn’t stopped the market from performing relatively well. That’s been entirely due to an increase in the price that investors are willing to pay for the market. The ASX 200 now trades on a forward PE ratio of 19x compared to the long-run average of 15x. Prices for stocks outside of resources are even steeper.
For the Australian market to continue to go up, it will need to come from increased earnings, probably led by the resource companies. And that’s dependent on commodity prices, especially iron ore. Given the significant supply of iron ore coming to market over the next few years, not many are betting on higher prices going forward.
Overall, it makes for a challenging outlook for both US and Australian shares. Other equity markets look more prospective, especially Japan and Europe.
S&P 500 earnings growth rate
Source: Robert Shiller
S&P 500 Trailing PE ratio
Source: Robert Shiller
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In my article this week, I look at the prospects for the battered and bruised LICs sector and whether lower interest rates can deliver a long-awaited turnaround in its fortunes.
James Gruber
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