The Story of Yesterday's Winner
Step into a time machine, set the clock back five years, and rebalance your portfolio knowing what you know today. What would you do? Buy 100% US large-cap growth stocks.
Between September 2013 and August 2018, US large-cap growth stocks compounded at a 17.6% annualized rate, versus 14.5% for the broad US equity market and 6.6% for the European market.
This is not exactly what the smart money would have predicted. We quants tend to prefer small value stocks to large growth stocks, and we prefer internationally diversified portfolios to domestically oriented ones. But the exact opposite strategy has worked for the last five years. It’s been the worst of times for international small value managers and the best of times for a 60%/40% FANG/Bitcoin portfolio.
What has driven this anomalous behavior? And will it persist? Should investors pretend it’s 2013 and overweight US large-cap growth? To answer this question, we studied the past five years of data to better understand exactly why US large-cap growth stocks did so well.
We found that US large-cap growth stocks outperformed due to surprisingly high US real earnings growth. Since 2013, real earnings of S&P 500 companies have grown at a rate of 4.2% per year, double the long-run average growth rate of 2.1% per year since 1926.
Figure 1: US Earnings Growth and Inflation
Sources: Robert Shiller's website, Ken French data library, and Verdad Analysis
This surprisingly fast earnings growth led to anomalously high returns for US growth stocks. The five-year performance of US growth stocks is 1.8x the historical average of 9.8% per year since 1926. On the other hand, the five-year performance of value is generally in line with its 92-year historical average since 1926.
Figure 2: US Value vs. Growth Returns
Sources: Robert Shiller's website, Ken French data library, and Verdad Analysis
US earnings growth has also been abnormally high relative to Europe in recent years. The trailing 12-month earnings per share of US companies are now over 50% higher than their level in 2007-08. On the other hand, the trailing 12-month earnings per share of European companies are now almost 20% below their peak in 2007-08. This divergence in profit growth represents a gap of 70 percentage points between US and European earnings per share.
Figure 3: Change in Trailing 12-Month Earnings per Share since 2007-08 Peaks
Sources: Wall Street Journal, UBS European Equity Strategy, Datastream. As of May 9, 2018
This divergence in earnings led European equities to dramatically underperform US equities.
With these last five years of anomalously high growth rates in mind, investors have bid up the valuations of US equities, as though expecting yesterday’s winner to keep on winning. US valuations are higher today than at any point since the tech bubble.
Figure 4: US Equity Valuations (1926–2018)
Sources: Ken French data library and Verdad Analysis
On a relative basis, the US equity market today is 66% more expensive than Europe in terms of price-to-book. This valuation spread is more than one standard deviation above the long-run historical average since 1975.
Figure 5: US/Europe Valuation Spread (1975–2018)
Sources: Ken French data library and Verdad Analysis
Investors responded to the surge in American corporate earnings by piling into US stocks, thereby pushing US equity valuations to notably high levels. Today, the US equity market appears expensive relative to its own history and relative to Europe.
But should investors bet on a continued growth surge? What could cause mean reversion in real earnings going forward? The past five years have been characterized by below-average inflation. Therefore, inflation could increase toward its long-run historical average of 2.9%, thereby slowing real earnings growth going forward. Alternatively, nominal earnings could revert toward their long-run average growth rate of 5.0% per year. This would reduce real earnings growth going forward, even if inflation remains at current levels. It’s also possible that both effects (higher inflation and lower nominal earnings growth) could occur at the same time over the next few years.
Investors who believe in mean reversion should be moving money out of US large-cap growth stocks and into US small value stocks and international equities. Growth rates don’t trend. Rather, they follow a random walk. Therefore, we don’t believe that investors should continue to bet on the high growth rates that have propelled US growth stock outperformance. Rather, investors should bet on the long-term base rates, which today—as always—favor small value and international diversification.