Wells Capital Management

Perspective

Economic and Market

November 13, 2015

Bringing you national and global economic trends for more than 30 years

The U.S. Stock Market Resides at a Unique Global Zip Code

James W. Paulsen, Ph.D
Chief Investment Strategist,
Wells Capital Management, Inc.

rewarded in recent years from overweighting U.S. stocks, may

want to consider a new zip code for some of their assets during
the balance of this recovery.

U.S. stock market diverges

Exhibit 1 compares the U.S. stock market to foreign stock markets

After following a similar path for much of the last 20 years, the
U.S. stock market has recently dominated global stock markets
moving to a unique zip code among world markets. Moreover,
while both sales and earnings per share among U.S. stocks
have mostly continued to rise, share earnings and sales have
generally been in a declining trend in both foreign developed
and emerging economies since 2011. Finally, because U.S.
stock performance has led global returns in the last four years,
the U.S. stock market has become increasingly expensive
relative to foreign alternatives both on a price to earnings and
on a price to sales basis.
The uncommonly wide divergence today between the
domestic and foreign stock markets primarily reflects a
significant difference in economic performances. For example,
while most global economies continue to struggle with very
sluggish or slowing growth and high unemployment, the U.S.
economy is one of the few in the world nearing or already at full
employment. We believe this rather odd and wide divergence
in the performance and character of the U.S. and foreign stock
markets suggest investors should be boosting equity exposures
abroad. Relative to the U.S., foreign stock markets are underowned, offer a better valuation, are surrounded by hospitable
rather than hostile economic policy officials, and are comprised
by companies whose earnings recovery is still in a much
younger stage compared to the aging earnings cycle facing
U.S. companies. Moreover, we suspect a forthcoming bounce in
global economic growth will soon shift interest toward foreign
stocks initiating a period of outperformance by international
stocks. Consequently, investors who have been solidly

since 1995. Chart 1 compares the U.S. market to the global stock
market excluding U.S. stocks and Charts 2 and 3 overlay the U.S.
stock market with the global developed world and with the
emerging world stock markets.
Until 2013, as shown in Chart 1, although the magnitude of
their respective movements differed, the U.S. and foreign stock
markets moved very closely directionally. For example, both rose
between 1995 until 2000, both then declined until 2003, both
rose again until 2007, both then collapsed in 2008 and both rose
again in tandem between 2009 until 2012. However, since 2013,
the U.S. stock market has diverged directionally with foreign
markets by the largest amount and for the longest time since at
least 1995. Since 2012, the U.S. stock market is up by about 50%
while the ex USA stock market has been essentially flat.
Chart 2 shows a similar divergence between the U.S. stock
market and the foreign developed world stock market. In this
case, the directional relationship remained quite close until
2014 when U.S. stocks continued to rise and foreign developed
markets declined. Indeed, since the end of 2013, foreign
developed stocks have declined by about 11% while U.S. stocks
have climbed an additional 12%.

Economic and Market Perspective | November 13, 2015

Exhibit 1: Stock markets

Chart 1
U.S. vs. rest of the world
Solid (left scale) -- MSCI U.S.A. Stock Price Index, natural log scale.
Dotted (right scale) -- MSCI World Free ex U.S. Stock Price Index,
natural log scale.
*All indexes in U.S. dollars

Chart 2

Chart 3

U.S. vs. rest of the developed world

U.S. vs. emerging economic world

Solid (left scale) -- MSCI U.S. Stock Price Index, natural log scale.
Dotted (right scale) -- MSCI Developed Country World ex U.S. Stock
Price Index, natural log scale.
*All indexes in U.S. dollars

Solid (left scale) -- MSCI U.S. Stock Price Index, natural log scale.
Dotted (right scale) -- MSCI Emerging Country Stock Price Index,
natural log scale.
*All indexes in U.S. dollars

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Economic and Market Perspective | November 13, 2015

Chart 3 shows that the directional relationship between the

U.S. stock market and the emerging stock market has not
been as close. However, outside of their significant divergence
during the late 1990s Asian crisis, the rest of the time between
1995 and 2012, emerging market and U.S. stocks moved
directionally quite closely. Since the end of 2011, however,
emerging market stocks have declined by about 10% while U.S.
stocks have risen by almost 66%!
As shown by all three charts, while the U.S. stock market
eclipsed its previous all-time record highs several years ago,
neither developed nor emerging stock markets have been able
to reach previous record highs in this recovery. What stands out
is not that the U.S. stock market has outperformed foreign stock
markets. This has happened several times in the past. Rather,
it is the magnitude and persistence of directional divergence
between the U.S. stock market and foreign markets which is
exclusive. The fact that the U.S. stock market has moved to a
different zip code in recent years relative to global markets is
historically unique. Most importantly, what does this unique
divergence currently imply about the future risk-reward profile
of the U.S. stock market relative to foreign alternatives?

Since 2011, in both developed and emerging economies,

earnings performance has diverged from the U.S. experience.
As shown in Exhibit 2, the degree and duration of this earnings
divergence is unprecedented. Interestingly, as shown in Exhibit
3, foreign sales results have only diverged significantly from
those in the U.S. since mid-2014, although the divergence has
been one of the largest outside of a recession since at least
1995 (see Chart 7). The fact that U.S. earnings performance has
diverged more than sales performance reflects how much better
U.S. companies have been at maintaining and expanding profit
margins compared to most foreign companies.
Fundamentals have clearly diverged in this recovery in favor of
U.S. companies. The question is whether this rare fundamental
divergence is ultimately resolved by foreign companies (and
thus foreign stocks) experiencing far greater fundamental
improvements compared to U.S. companies during the balance
of this global recovery?

U.S. company fundamentals diverge

The U.S. stock market has directionally diverged from global
markets primarily because U.S. company fundamentals
(earnings and sales trends) have directionally diverged from
most foreign companies.

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Economic and Market Perspective | November 13, 2015

Exhibit 2: Earnings
Chart 4
Trailing 12-month earnings per share*
U.S.A. vs. rest of the world
Solid (left scale) -- EPS on MSCI U.S. Stock Price Index, natural log scale.
Dotted (right scale) -- EPS on MSCI World Free ex U.S. Stock Price Index,
natural log scale.
*All indexes in U.S. dollars

Chart 5

Chart 6

Trailing 12-month earnings per share*

Trailing 12-month earnings per share*

Solid (left scale) -- EPS on MSCI U.S. Stock Price Index, natural log scale.
Dotted (right scale) -- EPS on MSCI Developed Country World Free ex
U.S. Stock Price Index, natural log scale.
*All indexes in U.S. dollars

Solid (left scale) -- EPS on MSCI U.S. Stock Price Index, natural log scale.
Dotted (right scale) -- EPS on MSCI Emerging Country Stock Price
Index, natural log scale.
*All indexes in U.S. dollars

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Economic and Market Perspective | November 13, 2015

Exhibit 3: Sales
Chart 7
Trailing 12-month sales per share*
U.S. vs. rest of the world
Solid (left scale) -- SPS on MSCI U.S. Stock Price Index, natural log scale.
Dotted (right scale) -- SPS on MSCI World Free ex U.S. Stock Price Index,
natural log scale.
*All indexes in U.S. dollars

Chart 8

Chart 9

Trailing 12-month sales per share*

U.S. vs. rest of the developed world

U.S. vs. emerging economic world

Solid (left scale) -- SPS on MSCI U.S. Stock Price Index, natual log scale.
Dotted (right scale) -- SPS on MSCI Emering Country Stock Price Index,
natural log scale.
*All indexes in U.S. dollars

Solid (left scale) -- SPC on MSCI U.S. Stock Price Index, natural log scale.
Dotted (right scale) -- SPS on MSCI Developed Country World Free ex
U.S. Stock Price Index, natural log scale.
*All indexes in U.S. dollars

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Economic and Market Perspective | November 13, 2015

U.S. stock market valuations diverge

As illustrated in Exhibits 4 and 5, U.S. stock market valuations are
becoming rich relative to foreign alternatives.
On a price to sales ratio basis, Exhibit 4 shows U.S. stocks have
not been as expensive as they are today relative to the rest of the
world since the dot-com top in 2000. This valuation divergence
has been expanding regularly against both developed and
emerging stock markets since 2011. Finally, on an absolute basis,
the U.S. price to sales ratio has not been as high as it is today
since 2001 while the price to sales ratios among both developed
and emerging stock markets have yet to reach their respective
peaks at the end of the last recovery in 2007.
The price to trailing 12-month earnings ratios shown in Exhibit
5 are more difficult to interpret because of the much greater
cyclical volatility experienced by earnings compared to sales
performance. However, compared to the rest of the world (Chart
13), the relative U.S. price earnings ratio began this recovery
cycle on par with foreign price earnings ratios but has traded
to an expanding premium since 2013. As shown, the only time
the relative foreign price earnings ratio has been as cheap as it
is today in the last 20 years was at the dot-com top in 2000-2001
and briefly again in 2005-2006.

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As shown in Charts 14 and 15, most of the current relative

foreign price earnings undervaluation resides among
emerging market stocks. However, while foreign developed
stock markets traded at a premium price earnings ratio
relative to the U.S. stock market between 2011 until late 2014,
they currently trade at a discount valuation.
Overall, relative valuations seem to more than fully reflect
weaker foreign company fundamentals. U.S. valuations
are higher relative to foreign markets despite fundamental
U.S. sales and earnings performances which have been far
superior. That is, even adjusting for much better fundamental
company performances, U.S. stocks still appear rich relative to
most foreign stocks.

Economic and Market Perspective | November 13, 2015

Exhibit 4: Price to sales

Chart 10
Price to sales ratio*
U.S. vs. rest of the world
Solid (left scale) -- P/S Ratio on MSCI U.S. Stock Price Index
Dotted (right scale) -- P/S Ratio on MSCI World Free ex U.S. Stock
Price Index rate.
*All indexes in U.S. dollars

Chart 11

Chart 12

Price to sales ratio*

U.S. vs. rest of developed world

Price to sales ratio*

U.S. vs. emerging economic world

Solid (left scale) -- P/S Ratio on MSCI Stock Price Index.

Dotted (right scale) -- P/S Ratio on MSCI Developed Country World
Free ex U.S. Stock Price Index .
*All indexes in U.S. dollars

Solid (left scale) -- P/S Ratio on MSCI U.S. Stock Price Index.
Dotted (right scale) -- P/S Ratio on MSCI Emerging Country Stock
Price Index.
*All indexes in U.S. dollars

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Economic and Market Perspective | November 13, 2015

Exhibit 5: Price to earnings

Chart 13
Price to trailing 12-month earnings ratio*
U.S. vs. rest of the world
Solid (left scale) -- P/E Ratio on MSCI U.S. Stock Price Index.
Dotted (right scale) -- P/E Ratio on MSCI World Free ex U.S. Stock Price
Index.
*All indexes in U.S. dollars

Chart 14

Chart 15

Price to trailing 12-month earnings ratio*

U.S. vs. rest of developed world

Price to trailing 12-month earnings ratio*

U.S. vs. emerging economic world

Solid (left scale) -- P/E Ratio on MSCI U.S. Stock Price Index.
Dotted (right scale) -- P/E Ratio on MSCI Developed World Free ex
U.S. Stock Price Index.
*All indexes in U.S. dollars

Solid (left scale) -- P/E Ratio on MSCI U.S. Stock Price Index.
Dotted (right scale) -- P/E Ratio on MSCI Emerging Country Stock
Pirce Index.
*All indexes in U.S. dollars

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Economic and Market Perspective | November 13, 2015

Summary and conclusions

Compared to the rest of the world, U.S. economic performance,
U.S. company fundamentals, and the U.S. stock market have
directionally diverged by more in this recovery than in any
during the last 20 years. With the U.S. seemingly residing at a
new zip code relative to the rest of the world, what does this
imply about the future?
Perhaps the contemporary global economic recovery will soon
end and the large directional divergence between the U.S. and
foreign stock markets will not be ameliorated. However, should
the current economic recovery persist, for several reasons we
expect foreign stock markets to begin closing the gap to the
U.S. stock market.
First, weak and non-synchronized global economic growth has
and continues to benefit U.S. stocks on a relative basis. As long
as global economic growth is weak and perceived as vulnerable,
the U.S. stock market will likely be favored as a safe haven with
better fundamentals and less credit risks. However, a bounce in
global economic growth would likely focus investor attention
on the diverse position of the U.S. recovery compared to the
rest of the world. We expect better economic growth about
the globe in the coming year highlighting the fact that the
U.S. has reached full employment while virtually no one else
has. Improved economic growth is good for most of the rest of
the world experiencing slack resource markets with room for
considerable fundamental improvements.

However, because the U.S. is uniquely near full employment,

faster economic growth would likely aggravate cost-push
pressures, worsen profit margins, and accelerate the pace of
interest rate hikes. Essentially, a global bounce in economic
growth would likely highlight the fact that the U.S. resides at a
different zip code than the rest of the world. And this realization
may prove to be the catalyst which closes the international
performance gap relative to the U.S. stock market. A bounce
in global economic growth would likely boost most foreign
stock markets but would result in a much more conflicted
environment for Wall Street.
Second, since foreign stock markets have been underperforming
the U.S. stock market for years, international stocks are probably
significantly underweighted in most portfolios. Should trends
turn more favorable for international stocks, more and more
portfolios may boost foreign equity allocations.
Third, as shown in Exhibits 4 and 5, foreign stock markets have
become increasingly attractive on a valuation basis relative to
the U.S. stock market. Indeed, because the U.S. stock market has
been so popular in recent years, it may be more extended on a
risk basis than almost any other global stock market.

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Economic and Market Perspective | November 13, 2015

Fourth, because the U.S. is nearing full employment, an ongoing

economic recovery is now likely to produce negative fallout for
the U.S. stock market (e.g., wage and cost-push pressures, profit
margin erosion, and higher inflation and interest rates which are
challenging for price earnings valuations). Conversely, because
most foreign economies are not near full employment, unlike
in the U.S., continued economic growth will only be good for
foreign stock markets. Finally, while policy officials are turning
hostile toward stocks in the U.S. (will the U.S. Fed start tightening
in December?), most foreign policy officials will likely remain
very supportive for stock markets abroad.
Finally, the U.S. earnings cycle is much older compared to
foreign economies. U.S. profit margins are near post-war highs
and cost-push pressures are likely to intensify. Conversely,
because most foreign economic recoveries are still in an earlier
phase of the current recovery cycle, companies in foreign stock
markets probably have a greater ability to improve fundamental
performances during the balance of this recovery.

Should an unexpected recession suddenly hit the global

recovery, all stock markets will likely do poorly but U.S. stocks
(because of their perceived safe haven status) should hold up
better than international stocks. However, if the current global
recovery persist for the next few years as we expect, foreign
stocks seem likely to finally sustain a period of outperformance
relative to the U.S. stock market.

Written by James W. Paulsen, Ph.D.

An investment management industry professional since 1983, Jim is
nationally recognized for his views on the economy and frequently
appears on several CNBC and Bloomberg Television programs, including
regular appearances as a guest host on CNBC. BusinessWeek named him
Top Economic Forecaster, and BondWeek twice named him Interest Rate
Forecaster of the Year. For more than 30 years, Jim has published his
own commentary assessing economic and market trends through his
newsletter, Economic and Market Perspective, which was named one of
101 Things Every Investor Should Know by Money magazine.

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The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational/informational purposes only, and should not be considered as
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