The major narrative of the 17-year period between 2008 to 2024 was that US stocks far outperformed international stocks: The S&P 500 index returned 10.7% annually on average, the MSCI EAFE Index 3.3% per year, and the MSCI Emerging Markets Index 1.9% per year. The outperformance is attributed to US exceptionalism fueled by a strong culture of innovation and entrepreneurship; more flexible labor markets; higher productivity; stronger consumer consumption driving demand for goods and services; a more favorable regulatory environment; lower corporate taxes; stronger intellectual property rights; and more open markets and trade policy.
The outperformance and the narrative of US exceptionalism has led many investors to ask why they should invest their equity allocation in anything but US stocks. I answered that question in this article by looking at the economic factors that led the US to faster growth. Here, I will dive deeper into the question by performing an attribution analysis, breaking down US outperformance into three possible reasons:
If the US exceptionalism is the main reason for the outperformance, faster growth in corporate earnings should explain most of the difference in returns.
In their May 2023 article “International Diversification — Still Not Crazy After All These Years,” AQR’s Cliff Asness, Antti Ilmanen, and Daniel Villalon found that from 2008 to 2022 the US outperformed EAFE by 4.7% a year, but once they controlled for valuations, the difference shrunk to 1.2% (and the gap was no longer statistically significant). In other words, about 75% of the outperformance of US stocks was related to a change in relative valuations, not the exceptionally strong earnings growth of the US.
The research team at Alpha Architect noted that the spread in valuations has widened since 2020. While US valuations bounced back after 2022, international valuations did not.
As the following chart from Alpha Architect shows, beginning in 2012, US stocks began outearning international stocks, providing the rationale for the US exceptionalism story. Is this likely to continue, especially when a small group of stocks (such as the “Magnificent Seven” stocks) accounted for most of the outperformance and the empirical research shows that abnormal earnings growth tends to revert to the mean far faster than the market expects — helping to explain the source of the value premium? (See “Forecasting Profitability and Earnings,” “Higgledy-Piggledy Growth,” “Returns to E/P Strategies, Higgledy-Piggledy Growth, Analysts’ Forecast Errors, and Omitted Risk Factors,” “The Level and Persistence of Growth Rates,” and “Persistence of Growth.”)
Unfortunately, there are no crystal balls that allow us to see if US corporate earnings growth will continue to be superior. As a helpful reminder against the projecting of the recent past into the future, consider the following historical evidence.
At the end of 1999, among the 10 largest global stocks by market cap were the technology leaders Cisco CSCO, Intel INTC, Lucent, Nokia NOK, Deutsche Telekom, and Nippon Telegraph & Telephone. These were the Amazon dot-coms and Nvidias of their day. As of March 17, 2025, Cisco’s market cap had fallen from USD 355 billion to USD 241 billion and Intel’s fell from USD 270 billion USD 104 billion. Lucent Technologies, which had a market cap of USD 228 billion, averted bankruptcy by selling its stock at a tiny fraction of the price it had commanded at its peak. Nokia’s market cap fell from USD 219 billion to USD 29 billion. Deutsche Telekom’s market cap fell from USD 216 billion to USD 186 billion, and Nippon Telegraph & Telephone’s market cap fell from USD 201 billion to USD 83 billion.
It is also important to recognize that there are policy factors that might lead to a narrowing (or elimination) of the earnings gap that has favored the US since 2010.
Europe announced significant fiscal stimulus to boost defense spending in response to Ukraine conflict and concerns over reduced US support. Here are the key measures:
These measures reflect Europe’s commitment to strengthening its defense capabilities and supporting Ukraine amid shifting geopolitical dynamics. They will stimulate economic growth (and corporate earnings) and likely increase inflation. Both effects are likely to put upward pressure on European interest rates and provide support for the euro versus the dollar.
There have also been significant signs that European leaders have acknowledged that their economies have stagnated due to excess regulation. Several examples illustrate this sea change:
These changes indicate that European policymakers are actively addressing the regulatory burden that has contributed to economic stagnation, aiming to create a more competitive and innovative economic environment similar to that of the US. These changes could succeed and lead to a narrowing of the discount in price/earnings ratios at which international companies are trading.
We turn now to the third leg of the attribution stool, currency effects. When an investor buys an international asset, they must sell their US dollars and buy the local currency to purchase. Has that affected international investments after the global financial crisis?
At the start of the period between 2008-24, the Bank for International Settlements showed the US dollar value was 96.63. At the end of the period the US dollar value had increased to 113.73. The result is that international equities faced a headwind of almost 18%.
Could the changes in European fiscal, monetary, and regulatory policies change the tailwind into a headwind? As of March 15, the dollar value had fallen to 110.21.
There is another factor that could negatively affect the value of the dollar and provide a tailwind for international equities. The US dollar’s share of global central bank reserves has been declining in recent years. According to the IMF’s Currency Composition of Official Foreign Exchange Reserves report, the US dollar’s share fell to 54.8% of total official foreign-exchange reserves in the first quarter of 2024, down from 71% in 2001. When including gold holdings, which account for 15% of global reserves, the dollar’s share drops further to 48.2%.
This decline can be attributed to several factors:
The implication of this trend is significant as it could lead to higher interest costs on US debt due to reduced demand at a time of large fiscal deficits.
While the US dollar remains the preferred currency for central bank reserves, its declining share suggests a gradual shift in the global financial landscape, with potential long-term implications for US economic dominance.
The narrative of the past 17 years has been the outperformance of US stocks, with the main explanation being US exceptionalism. Our analysis reveals that a statistically insignificant portion of this outperformance stemmed from superior earnings growth, with the lion’s share driven by expanding US valuations and a strengthening dollar — raising concerns about its sustainability. History teaches us that such trends are rarely permanent, with economic regimes and relative valuations prone to reversion.
Ignoring international diversification carries the risk of missing potential upside as European nations implement fiscal and regulatory reforms. These reforms could stimulate economic growth and corporate earnings, potentially leading to a re-rating of international equities. While achieving true diversification can be challenging, a market-cap-weighted approach to international stocks offers a sensible starting point for mitigating risk and capturing potential opportunities beyond US borders. Remember, resisting the temptation of chasing past performance is crucial for long-term investment success.
