It is difficult to go a day without coming across another article explaining US equity exceptionalism. This is unsurprising given that performance has been outstanding both in terms of its magnitude and duration. Yet there is a concerning aspect with many of these pieces – rather than simply explain what might have caused exceptional returns from the US equity market, they almost always make the case for their persistence being inevitable. Whenever investors talk and behave as if the future is both obvious and unavoidable it is sensible to be wary – this time is no different.

Prolonged outperformance is always exceptional

The idea of exceptionalism is not unique to US equities, it is the same argument that is always made about an asset class that has delivered unusually high returns for a sustained period of time. Emerging market equities, dotcom stocks and Japanese equities have all enjoyed spells of being defined in such a way after prolonged and pronounced outperformance. This is driven by the tendency of humans to extrapolate both past returns and the stories which accompany them.

Duration is also an incredibly important factor. The longer such trends persist the harder it becomes to see anything else occurring in the future. Contrarians aren’t broken by the magnitude of poor performance they are broken by its length.

The core point of the exceptionalism claim (for any asset class) is that what has occurred is a secular, permanent feature of markets rather than some temporary phenomenon. Whenever an asset class enjoys exceptional returns for an extended period this argument must be made – it is essential to its continued success. Why? Because as investors are persuaded / compelled / forced to invest more in that asset the only way they can justify it is to make the exceptionalism case.

As a portfolio manager prepares to tell their Investment Committee that they are increasing their allocation to US equities they can hardly produce a PowerPoint slide saying that they are capitulating after significant performance pressure or that they are probably investing at the peak of a cycle. Rather they have to say that US equities are truly exceptional, and they now believe that the advantages are structural and will last in perpetuity.

This is not to say there is nothing exceptional about US equities (more on that later), but simply that the same type of stories justifying the same types of behaviour are always told around asset classes which deliver lengthy spells of uncharacteristically high returns.

If you are ever in doubt about why investors are making the decisions that they are – rest assured that the answer is almost always past performance.

What do we really mean by exceptional?

Asset class exceptionalism is always identified after the fact – but what does it mean to be exceptional?

Although often left undefined, when people talk of exceptionalism they are referring to features that afford an asset class the ability to deliver enduring outperformance. Its causes can be placed into three groups:

Structural: Permanent (or at least very long-term) aspects of an investment that proffer it a return advantage.

Cyclical: Factors that have a variable influence on an asset class’s returns – largely dependent on capital / economic cycle. 

One-off / Singular: Exceptional returns for a period driven by a one-off confluence of variables within a complex system at a particular point in time – these are not permanent nor likely to be repeated.

Exceptional returns are almost always a convergence of these factors, but our tendency is to greatly overstate the role of structural drivers over cyclical phenomena. We are also liable to entirely ignore the influence of one-off factors.

Let’s take one version of the US equity exceptionalism justification. US markets are the most shareholder-friendly in the world, they allow for the emergence of large, significant and successful companies. The US is the market that allows more of the gains of capitalism to go to companies and the individuals that own them. (This may come at the expense of other elements of society, but that is not for this post).

This is a structural argument and one which – in broad terms – is very common. Is it true? Possibly. Does it lead to exceptional stock market returns? Maybe, but few people were saying so in 2010.

But what about the one-off argument? At the start of this exceptional run of performance the US equity market was in the relative doldrums so had undemanding valuations. This was combined with a wave of material technological developments that transformed the economic and financial market landscape and led to the full emergence of a range of staggeringly successful and sizable US listed companies. The financial magnitude of their successes allowed them to make gargantuan investments which further bolstered their dominance.

Here we have a mix of variables – some combination of situational luck and structural circumstance that fostered a pattern of returns that have led to great confidence in ongoing exceptionalism. Yet even if this explanation were to be right (it is not – it will be at best incomplete), it is difficult to ascertain how much of the high returns we have witnessed are to do with something ingrained in US markets and how much is due to the emergence of some exceptional tailwinds.

The answer is always a complex web of factors and nowhere near as simple as any explanation that we might find here.

What does US exceptionalism mean for future returns?

Exceptionalism is justification for past outperformance, but what does it mean for future returns? Continued strong returns is the simple answer, but that is not sufficient. If we ignore the short-term vagaries of sentiment, then claims about equity market exceptionalism must be about superior earnings growth. The central argument of US exceptionalism is that its earnings will grow faster than other markets (let’s ignore starting valuations for the moment). This has certainly been the case over the past decade, but is it set to persist indefinitely?

One of the challenges is where the earnings growth advantage has arisen in recent years – it has been dominated by the ‘Magnificent Seven’ stocks. Although the fundamental performance of these names has been (in aggregate) undeniably outstanding, there is an inherent challenge in the largest companies in the world delivering EPS growth north of 30% per annum if nominal GDP is somewhere around 5%. These two figures are likely to converge over time and I could hazard a guess in which direction. Of course, companies can also claim a greater share of overall growth (even if the rate of economic growth is modest) but this gets increasingly difficult at scale.

This is not to paint a negative outlook for these companies, but rather to make the point that continuing to deliver exceptional results gets harder from here (even ignoring what is already reflected in valuations).

The importance of the Magnificent Seven on the exceptional status of the US equity market also raises an important question. What exactly is it that makes the US exceptional? If it is a broad statement on the overall environment then we should expect equally impressive outcomes from small caps or an equally weighted version of the market. Or is it more that the US is a more fertile environment for the emergence of hyper-successful and sizeable companies? This distinction feels important.

What is the right price for an exceptional market?

At this point of a market cycle simply mentioning valuations can seem somewhat arcane and is often met with a roll of the eyes, yet even exceptionalism should have a price.

One of the comments I often hear is that the US has consistently outperformed despite being expensive ‘forever’, so valuations are clearly meaningless. This is not true – for much of its decade or more of outperformance the US equity market hovered around its long-run average valuation level relative to other global markets, it is only in more recent times where the valuation premium has reached extreme levels.

Saying that valuations are irrelevant makes no sense. They are a terrible timing tool and often an overly simplistic way of assessing return prospects, but that does not make them redundant.

Imagine that US equities come to trade at 100x cycle adjusted earnings and the rest of the world 25x – are valuations still a non-factor for future return expectations? I doubt it. If we believe that there is a return premium for US exceptionalism, we should also be willing to consider what we are comfortable paying for it. If we pay too much, we might not get a premium.

Let’s make it into a very simple question: Over a long-run horizon what earnings growth advantage do we expect a set of US listed companies with global revenue streams to hold over a set of non-US listed companies with global revenue streams?

If we can answer that then we should be able to think about what a reasonable price to pay for that advantage might be. I am not sure what the solution is, but it shouldn’t be that the price we pay doesn’t matter at all.

Everyone already behaves as if US equities are exceptional

One of the puzzling aspects of conversations around the US equity market at the current time is the notion that US exceptionalism is underappreciated. Let’s be clear here – the US equity market represents over 70% of globally equities. The next largest single country is around 5% (Japan).  The fortunes of the majority of investors are inextricably tied to the future performance of the US equity market – both the continued outperformance of the market and investors actively growing their exposure increases this reliance. The size and valuation of the market is reflecting the belief that the US has been exceptional and will continue to be so.

Another behavioural oddity that the current situation of the US equity market is a fascination with minor relative positions over very large absolute positions. In simple terms – an investor with 68% of their portfolio invested in US equities will often seem to worry more about being 2% underweight than the 68% absolute allocation they hold in one market. Over time only one of these things will matter.

A profound challenge with increasing market dominance and concentration is that diversification becomes incredibly difficult. Not only does the outperforming asset (US equities in this instance) passively become a more prominent feature of most portfolios, but the development and reinforcement of the ‘exceptionalism’ narrative means that investors don’t want to be diversified – why would we? We just want to own the exceptional option.

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Given the current fervour for US equities, this will no doubt be read as a bearish piece on the asset class – it is not – it is and should remain an important part of most portfolios. We should, however, always be cautious of situations where investor narratives and behaviours suggest the future is far more certain than it can possibly be.

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