The U.S. is on a winning streak. Four years running, through political turmoil and Covid-19, American stock markets have beaten the world. As we hit the second anniversary of the pandemic, investors should be asking whether it can continue.
Few would have predicted it would turn out this way. The U.S. has had the worst response to Covid in the developed world by two key measures: the highest death rate and lowest vaccination rate. Yet U.S. stocks have returned more than double the gains in the rest of the world since the end of 2019.
Broadly there are three ways to think about this U.S. market exceptionalism.
A superior economy
The economy was certainly a winner. Lavish government subsidies meant household incomes rose as the economy slumped in early 2020, the first time they’ve ever gone up in a recession—and that positioned the U.S. to have among the best growth of any developed country since 2019 (South Korea, Israel and Ireland did better, but are much smaller). Economic growth fed profits, and that certainly explains some of the U.S. stock market’s outperformance: Estimates for year-ahead earnings are 20% higher than before the pandemic, more than double the rise in the rest of the world.
Yet, U.S. stocks are up about 50% since the end of 2019—so higher profits account for only part of it. The rest is a rise in the valuation, anticipating faster profit growth in the future. Is that reasonable? Not if the economy merely returns to its previous path of growth. Not if the huge rise in government and corporate debt of the past two years damps future expansion, as should be expected. And not if the economy is reliant on government stimulus for growth, as that cannot be sustained either politically or economically.
The greatest companies
A focus on America’s leading corporations can provide succor to U.S. bulls. Companies didn’t all do well. But of the world’s pandemic winners, many were in the U.S., and not only in obvious areas like Zoom or video streaming.
The biggest online-platform stocks—Alphabet, Microsoft, Apple, Amazon, Meta Platforms (formerly Facebook )—are American, and the pandemic accelerated their growth. In parallel to concern about coronavirus was concern about the environment, and the biggest winners of both are in the U.S.: Moderna and Pfizer due to highly profitable mRNA vaccines, and Tesla due to electric cars. The U.S. has also been at the center of the boom in initial public offerings and reverse listings via special-purpose acquisition companies, or SPACs. Many of the new companies will disappoint, or already have, but some could become the megacap stocks of the future.
The U.S. has long had a highly flexible and innovative economy, too, despite concern about monopoly power. If U.S. companies are better able to adapt than international rivals, they should be able to cope better with disruption—not merely from the pandemic, but from the geopolitical, social and environmental upheaval that could be on the way. If true, this would justify a higher valuation.
Equally, the U.S. has historically accepted more creative destruction than other large countries, adapting more quickly after a crisis. While state support prevented many corporate failures over the past two years, the U.S. market is generally quick to reallocate capital from past winners to chase potential future successes, helping the market pick up new trends more quickly than many others.
However, the U.S. hasn’t always been so exceptional, which undermines the argument. From 1950 to 2010, U.S. stocks returned 6.9% a year above inflation, including dividends, while the rest of the world returned 7.6%, according to market historians Elroy Dimson, Paul Marsh and Mike Staunton (compounded, that small difference becomes vast). Only since 2010 has the situation reversed, with Europe in crisis and the U.S. led up by Big Tech stocks. The recent U.S. dominance might continue, especially with today’s giants spending so much on research and development, but history isn’t supportive.
Rather than the greatest companies, the risk is that the U.S. simply has a market dominated by companies that benefit more from low interest rates. Big Tech valuations soared due to the Federal Reserve providing exceptional support and bond yields tumbling. If a stronger economy leads to higher bond yields, expected future profits might be worth less than they are today and U.S. stocks might suffer even as growth continues, the opposite of what usually happens.
It’s all just speculation
The truly bearish approach is to say that all these attempts to search for a story about the past two years miss the real point, which was the rise in speculation. The important change in the structure of the stock market was the arrival of millions of individuals flush with stimulus checks and with time on their hands to gamble.
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Stephen King, senior economic adviser at HSBC and author of “Grave New World,” points out that in the late 1980s many strategists thought Japan’s successful industrial model explained Japan’s stock-market excess. “But they found out it was just another bubble,” he says. The country’s stocks are still far below their 1989 peak.
I remain hopeful that the froth isn’t indicative of an irrational inflation of the entire market. I prefer to explain the U.S. lead with the first two reasons: the startling nature of its economic recovery and profits, combined with a big boost to valuations from lower bond yields.
Those were great things to have, but are in the past. I expect the end of the pandemic to help economic growth, allowing bond yields to hold on to their early 2022 gains and maybe rise further, a headwind for the gigantic stocks that dominate the U.S. market. That will drag on the U.S., even as cheaper stocks more sensitive to the economic cycle should be able to avoid the pain of higher yields. Since there are more of those elsewhere, that should give foreign markets a chance to pull ahead. Put another way: As Covid retreats, so should U.S. exceptionalism, at least in the stock market.
Mr. Mackintosh is a senior markets columnist for The Wall Street Journal in London. Email him at email@example.com.
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