US stock market dominance and reversion to the mean

When discussing the equity market outlook, a key topic is whether the recent period of US outperformance is set to continue or reverse. Some investors think about relative valuations to argue that US outperformance is unsustainable, while others look to sectoral differences and reach the opposite conclusion.

We take a different perspective and see if we can learn anything from historical precedents of protracted periods of stock market leadership. The bottom line is that continued US outperformance, while not impossible, would be going against the grain of historical precedent.

To analyse historical returns, we’ve blended several data sources to create a continuous history of equity market returns across the largest industrial nations (i.e. the G7) stretching back to 1900. We’ve used a combination of Bloomberg data, data sourced from Kuvshinov and Zimmerman’s “The Big Bang: Stock Market Capitalisation in the Long Run” (2021), and the Jordà-Schularick-Taylor Macrohistory Database.

We start by simply ranking returns across nations, calculating US dollar returns from investing in each of the equity markets over rolling five-year periods as far back as possible. Data interruptions around WW1 and WW2 mean that the number of markets fluctuates over time.

The chart below shows the rank of the US (in orange), alongside the rank of the median market for which data are available (in blue). We know that the US has been top of the podium over the past decade, but investors with short memories might forget the periods when it was at or close to the bottom of the pile. On average, the US has ranked between 3^rd or 4^th place on the leaderboard: almost exactly in line with what we would expect from a market selected at random.

What goes around, comes around. The current period of US market dominance is the longest since 1900, but that persistence is a historical anomaly.

Second, we assess whether a relationship exists between stock market dominance today and future returns. The US represents the highest share of the global stock market today at around 70% of the G7 by market capitalisation. But market shares fluctuate over time. The UK and France have seen their weights halve since the beginning of the 20^th century.

However, most interesting is Japan. In the late 1980s, the Japanese stock market accounted for 45% of the total G7 stock market. For three years, it was the single largest G7 equity market. A decade later, however, and annual Japanese equity returns had been 15% lower than the G7 median. The chart below illustrates that in Japan’s case at least, there has been a strongly negative correlation between a high stock market weighting and subsequent 10-year returns.

We can see a similar relationship for other G7 countries. For example, Italy’s period of persistent underperformance in the last couple of decades came after it briefly hit an all-time high 3% of the G7 market cap in 2000. The UK outperformed the G7 median by nearly 10% per annum from the mid-1970s to the mid-1980s after dipping below 5% of the global market in 1974.

In summary, G7 markets have tended to outperform their peers when starting from lower-than-normal weights in the global index. The US is in the opposite situation today with its weight close to an all-time high.

To summarise, the recent phenomenon of US stock market outperformance may persist for the next decade, but it would be historically unusual. Over the long run, US returns have ranged between the top-end and the bottom-end of the G7 league table. On average, it has been in the middle of the pack in either 3^rd or 4^th position.

In addition, big has not typically been beautiful. Looking across the G7, markets with an abnormally large market share have tended to underperform over the subsequent decade. Japan is the poster-child of this phenomenon, but we have seen a similar phenomenon elsewhere.

Can the US continue to outperform? Of course it can, but you need to believe the last 120 years of G7 equity market performance data are not relevant to think that is the likely outcome.

We therefore believe that the arguments for international diversification[1] are strong, arguably to an even greater extent than they have been in the past given the extent of the current US dominance of global equity markets.  

[1] It should be noted that diversification is no guarantee against a loss in a declining market.