This paper by Vanguard seeks to outline and determine if the US market will continue to out preform for the next decade. As we enter 2021, it’s important to guide our future expectations about returns. There are some ways in which we can predict future long term growth trends across regions – a common method is using PE ratios, but other methods exist like vanguard’s frame work. Fortunately, we will see here that both the PE ratios and Vanguard’s framework are predicting the same thing – poorer future US returns and higher international returns.
Explaining past returns
Vanguard uses some framework developed by Ferreira and Santa-Clara, Bogle, and Bogle and Noland. But the framework can be broken down into 4 major parts – Change in valuations, Earnings growth, Dividend yield, and foreign exchange returns.
Seeking to breakdown past returns we see that the major factor in America’s out performance this past decade was a valuation change. While the next three factors – foreign exchange returns, dividend yield, and earnings growth explain the remaining portion.
Looking at the valuation change, Vanguard suggests that this is largely due to macroeconomic factors.
Further, for earnings growth they suggest that earnings have grown faster in the US than in other countries because of higher GDP growth rates. A positive beta coefficient of 1 in the relationship between revenue growth and GDP growth indicates that the average revenue growth will equal economic growth. Over the past 10 years, US growth has exceeded international growth by an average of 1.8% per year. In addition, to earnings growth, profit margin for US firms has grown and remained high in comparison to past data – see figure 3. There’s some argument that this will remain into the future.
Next is dividend yield, dividend yield is the product of earnings yield and payout ratio. Lower dividend yield can be explained by both of these factors. The lower earnings yield (inverse of the PE ratio) is the result of higher stock market valuations. And the lower payout ratio is explained by the relative tilt US markets have had towards growth companies. Comparing US markets to international there has been a 10% lower payout ratio in the US compared with international markets.
Finally, are foreign currency returns. The past 20 years of US dollar performance can be described by two trends. Dollar depreciation explains about 3% of investor’s return on non-US assets from 2000-2010. But the following decade resulted in a loss of 1.5% as trade, productivity, and interest rate differences explained most of the changes in the real rates. As the US economy expanded, demand for US dollars increased and the currency appreciated during the following decade.
The next 10 years can be explained by using their capital markets model. While they note there is still some uncertainty Vanguard expects we will see “that US equity returns will be about 8 percentage points lower than the last decade on an annualized basis.”
Lower return expectations for the US relative to international equity is mainly a function of the higher initial valuations for the US. In figure 5 Vanguard shows the statistical relationship between US and international equities. It shows an inverse relationship between starting valuations, measured as the ratio of the broad equity market price to the 10- year rolling average inflation adjusted earnings, and future 10-year returns. Further, the relationship is supported by prior research showing that mean reversion in equity valuations is conditional on the inflation and interest rate environment. Vanguard’s expectation of valuation contraction accounts for roughly 2.2% of the difference in expected returns for the coming decade.
While historically equity valuations have displayed mean reversion proprieties Vanguard’s outlook is not dependent upon mean reversion. They also see that low interest rates tend to accompany periods of lower GDP growth and as a result lower earnings growth. Currently, the probability of international equity out performance is sitting around 80% for Vanguard’s models.
Summary and Portfolio Return Outlook:
Despite Vanguard’s predictions of lower US equity returns, there are a lot of inherent uncertainties in the outlook which support a generally balanced equity allocation. They recommend balancing a portfolio with US and international equities. The reason being is a 100% US allocation might produce a return enhancement of .3-0.6% over the decade but if international equities out perform the return shortfall would be around 0.8-1.4%. Investors who maintain a balanced portfolio may not get the best returns possible but they will avoid the risk of choosing incorrectly and missing out on higher returns.
“The past 10 years have been tremendous for U.S. stocks relative to their international peers, largely because investors expected the U.S. to grow faster and it did. Now, however, higher valuations and slower earnings growth in the U.S. relative to the past decade make future out-performance unlikely. As a result, we expect that investors who maintain globally diversified equity portfolios will be rewarded in the years ahead.”
Overall, you’re likely better off for the next decade in reallocating towards a balanced portfolio of international and US equities. Diversifying across assets and geographical locations has tended to provide risk adjusted returns, while not diversifying often produces lower returns overtime. If you’re looking to invest for the long-term diversifying across US and International stocks will likely produce better outcomes than either one alone. If you aren’t investing in the markets yet try using m1 finance (you’ll get an extra $10 dollars with the referral link) it’s a great platform for long term investing. And finally, if you’re looking for further ways to enhance returns check out our high risk and ultra-high risk newsletter.
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