Excerpt from “The Long Run is Lying to you” March 2021 by Cliff Asness
It’s common knowledge that the stock market in the USA has crushed the rest of the world (I’ll use EAFE here to proxy for non-U.S. developed market equities) since the peak of the Japan bubble (call that the end of 1989) or over the last, say, ten years, right? Well, yes. But here we are interested in how much of the outperformance is from the USA’s fundamentals (or perhaps carry) beating the rest of the world versus the USA’s valuations richening versus the rest of the world.
From 1980 to 2020 the USA has outperformed EAFE by 2.1% per annum. A hefty number (though not statistically significant). Now, as you might guess, there have been some changes in absolute and relative valuation over this period.
We see a giant repricing with the USA getting relatively much more expensive on CAPE and ending effectively at a peak. You know what regression is coming right?
I regress the difference in annual return (USA minus EAFE) on the contemporaneous difference in annual percentage change in CAPEs over 1980–2020:
USA minus EAFE = 0.4% + 0.94 * change in valuation, R2 = 91.5% (0.7) (19.6)
So, when we adjust for the change in relative valuation, the return differential shrinks from an economically (if not statistically) significant 2.1% per annum to an insignificant (both ways) forty basis points. The victory of the USA over EAFE for the last forty years is almost entirely coming from it getting relatively more expensive.
Basically, if you were estimating long-term expected returns going forward, would you want to build in CAPE appreciation going on forever at the rate in the graph above, or would you remove that effect and look at the intercept? I think the answer is obviously the latter and hope by now you agree!
This has real implications for asset allocators where the “removing the effects of massive changes in valuation” method argues for much more non-USA exposure than one would get just looking at simple realized returns and assuming they are a fair sample for the future (and this is without assuming any mean reversion from the historic high valuations of USA vs. EAFE).
Basically, those who’ve changed their portfolio, selling their international stocks and putting it in the USA, because of the 30 years of USA outperformance, are kind of building in the assumption that relative CAPEs, which have gone up 2-3x for the USA vs. EAFE, do so again in perpetuity. Good luck.
Submitted March 15, 2021 at 11:16PM by Erland_Brynjar https://ift.tt/2OrLJj3
