What determines equity returns

Commentary by Qian Wang, Vanguard Chief Economist, Asia-Pacific, and Global Head of Vanguard Capital Market Research

On our Market Views tab: Why stocks and gold have rallied in tandem

Key points

• Factors besides valuations often determine short-term equity returns. But valuations act like gravity over the long run, bringing returns closer to historical norms.
• U.S. equity valuations are stretched, which not only could continue for a while but also makes them more vulnerable to shocks in the near term.
• With increasing economic fragmentation worldwide, global market diversification becomes even more important in offsetting risk.

For a few years now, we’ve emphasized how overvalued U.S. stocks have become. And yet, driven by large tech companies, U.S. stocks continue to hit all-time highs with astonishing regularity. But unlike what we saw in the dot-com environment more than 25 years ago, U.S. stocks aren’t necessarily in a bubble.

Today’s tech stock market leaders are generating real, strong profits. Factors including innovation, productivity, favorable regulation, and strong corporate balance sheets can partly justify their lofty prices.

However, the market often gets ahead of itself. When valuations are stretched with high hopes for the future, downside risk often outweighs upside potential.

Elevated valuations alone typically don’t trigger market corrections. But they do make the market more vulnerable to shocks—such as from a recession or geopolitical events—that can trigger a correction.

Our research shows that over longer periods approaching 10 years or more, valuations act like gravity, eventually pulling returns back toward their historical norms. However, over shorter time horizons, economic and earnings growth play greater roles in determining returns.

Accordingly, in today’s market environment, we need to watch macroeconomic developments and earnings growth closely. Despite our more muted long-term return outlook, the combination of continued economic and earnings growth and expected Federal Reserve monetary policy easing to cushion downside risk— almost a Goldilocks scenario—could continue to support U.S. market returns in the near term.

However, renewed recession fears, disappointing earnings growth, or less-than-expected Fed easing (probably due to sticky inflation and a rise in long-term inflation expectations) could pose downside risks to the market when valuations are already stretched. So could any pullback in AI-related capital expenditures, which appear to have supported U.S. economic growth this year.

The promise that AI will change how we live has been a major tailwind for the U.S. market. If AI’s full potential is realized, U.S. companies could continue to deliver strong growth. However, international companies—especially those in developed markets—may benefit even more from AI once it is widely applied, commercialized, and integrated into the broader economy.

There’s “low-hanging fruit” overseas, where AI and automation can drive significant improvements in productivity and efficiency, allowing international companies to catch up to U.S. peers. On the other hand, if AI fails to deliver as expected, non-U.S. markets would likely have less of a pullback than U.S. markets.

It's not only AI that could spur greater growth overseas. In Europe, for example, increased defense spending or policy shifts that are more supportive of economic growth could boost productivity and earnings. In Japan, a return to normal inflation, stronger domestic demand, and continued corporate governance reform could lift earnings. Emerging markets, particularly China, present opportunities with technological breakthroughs and encouraging policy pivots but also risks due to persistent structural and geopolitical headwinds.

Furthermore, U.S. dollar appreciation contributed to the stronger relative performance of the U.S. market over the past decade. Currency exchange rates are less likely to be a tailwind for the U.S. market going forward. There is room for further depreciation in the U.S. dollar if global investors continue to diversify away from USD assets, and fiscal concerns could amplify this trend.
 

Our models indicate a likelihood that U.S. equities will lag non-U.S. stocks over the next decade. But there’s still a meaningful chance that U.S. stocks will outperform. No one should go “all in” on either U.S. or non-U.S. investments. Instead, investors should be diversified and, for the long term, may want to tilt their portfolios a bit more toward international.

Diversification is, of course, about more than just returns. In a more fragmented world, countries are striving for self-sufficiency and business cycles are becoming less correlated. This makes global diversification even more important for reducing risk.

Ultimately, skipping international diversification is a concentration gamble. Historical evidence and logic strongly support a globally diversified approach.