Why the American stock market reigns supreme

IF YOU had invested US$10,000 in the American stock market at the end of the year 2000, you would have had about US$27,000, after adjusting for inflation, by the end of 2023. If you had invested in global equities excluding America, you would have had only about US$16,000.

Wall Street’s outperformance this century has propelled America’s stock market to a 61 per cent share of global market capitalisation. That has not surpassed the all-time high reached during the 1960s, but it is close. And it is close even though America dominates the real economy far less than it did half a century ago, before the rise of Asian emerging-market giants and the fall of the Soviet Union. America’s share of the global stock market is 2.3 times its share of gross domestic product – a ratio that has never been higher.

What accounts for the boom? In part it continues a long-running phenomenon.

In the 20th century, American equities produced a real dollar return of 7 per cent per year, versus 4.9 per cent in the rest of the world, according to Elroy Dimson of Cambridge University and Paul Marsh and Mike Staunton of London Business School. That gap may sound small, but such is the power of compound interest that an investor in only American stocks would have ended the century more than seven times richer than an investor only in stocks elsewhere.

High returns are not unique to America: over the very long run, Australian stocks rival American ones. Some small countries with a few very big companies – such as Denmark, home of the drugmaker Novo Nordisk – can boast a higher ratio of stock-market capitalisation to GDP.

What makes America’s stock market unique is its combination of enormous size and high returns. Still more striking, its return advantage over the rest of the world has grown over time.

There are two ways for a stock market to outperform its rivals, setting aside ephemeral ups and downs (and America’s stock market is no more volatile than those of other major economies). One source of high returns is if the companies comprising the market make more profits. The other is for investors to value those profits more highly. America’s recent stellar record reflects primarily the latter effect.

In a paper last year, Cliff Asness, Antti Ilmanen and Dan Villalon of AQR Capital Management compared the American market with a currency-hedged index of large and mid-cap stocks in other developed countries. They found that once the effect of rising valuation multiples was stripped out, America’s outperformance fell by nearly three-quarters and became statistically insignificant. Today America’s valuations are unmatched: the US market trades at 24 times forward earnings, compared with 14 in Europe and 22 in Japan.

Europeans are so granola

There are logical reasons for America’s high multiples. It is home to the world’s “Magnificent Seven” technology titans including Apple, Amazon, Meta and Nvidia, making the market overall much more weighted towards growth stocks –shares in firms that are expected to be more profitable tomorrow than today, and so naturally are valued at higher multiples.

Europe does have its own group of stock-market giants – the so-called “Granola” group, which includes GSK, Roche, Nestle and Louis Vuitton – but they are mostly consumer-focused companies. Their growth prospects are not as good as those of the tech giants, at least if optimists about artificial intelligence (AI) are to be believed. The same goes for Japan’s dominant companies.

Since the global financial crisis, investors everywhere have bet heavily on growth stocks, while many old-economy sectors, such as banks, have faced headwinds, note strategists at Goldman Sachs. This has contributed to America’s valuation advantage. Investors are also drawn to American firms because they tend to reinvest more of their profits, increasing expectations of future growth. Last, American stocks are more valuable to investors because people know they can sell them in large quantities without moving the price much, as there are always lots of people who want to trade them at any given moment.

The result is that global stock markets have become concentrated on three levels: geographically in America, sectorally in technology stocks, and, at the company level in the Magnificent Seven (as well as at the top of European and Japanese industries). Just Apple, Microsoft and Nvidia together make up an astonishing 12 per cent of the MSCI All Country World Index of stocks.

The dominance is to a degree self-reinforcing. The next tech titan is much more likely to be located in America (perhaps having been relocated there) in part because of its capital markets. America’s high valuations make it an attractive place for firms to raise capital. And America dominates private markets as well as public ones – its share of venture-capital investments is at around 45 per cent – making it the best place both to raise early cash and in which to go public. Europeans regularly bemoan the loss of their most promising companies to the clutches of Wall Street.

One threat for the American market is that investors’ confidence in AI-related stocks dissipates. But technology firms, though pricey, are not yet valued at the truly eye-watering levels seen when the dot-com boom of the late 1990s was about to turn into a bust. Then, Cisco Systems, a networking firm, traded at over 125 times its expected earnings. And even excluding technology stocks, America’s share of global equities is still 55 per cent, up 20 percentage points since 2008.

Even if today’s divergence in multiples is justified, it will not in itself maintain America’s strong outperformance indefinitely. High valuations predict lower long-term returns – and America’s have only ever been higher in two previous economic cycles. According to Asness and his colleagues, “international diversification is still worth it, even if it hasn’t delivered for US-based investors in 30 years”.

That is especially so if emerging-market stocks grow in anything like proportion to their forecast share of global GDP. Today, China’s share is so small in comparisons like ours in part because they only count “free float”, excluding shares that international investors cannot buy because of legal restrictions. Count everything – which you might if China liberalised those restrictions – and China’s share more than trebles to almost 10 per cent. Goldman Sachs’ researchers predict that emerging markets’ share of global market capitalisation will rise to 55 per cent by 2075.

That does not mean America’s equity market is going to lose its status as the world’s biggest, however. Since overtaking Britain’s in 1902, it has been displaced only once: when Japan briefly occupied the top spot in 1989-90, before its markets crashed. Today, Japan is still in second spot, but its market is only about a tenth of the size of Uncle Sam’s; Goldman predicts that even in 2075 America’s market will be almost as big as China’s and India’s combined. It is a measure of the success of America’s stock market that, precisely because it has achieved such extraordinary dominance, its global share may be near its peak.

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