Avoid U.S. Investments? The 4 Drivers of Stock Market Returns and their Current Viability

Two prominent investment firms are arguing that this good be a good time for U.S. investors to sharply curtail or eliminate U.S. stocks and bonds from their portfolios. They see a lot of risk from U.S. investments. They also see better value and higher growth prospects in many overseas assets. Read Research Affiliates thoughts here and GMO’s thoughts here.

For any equity market, the return achieved can be broken down into four component parts. In the long term, the return is almost exclusively driven by dividends (growth and yield). Equity owners need to be compensated for providing capital to companies to help fund their long-term investments. That compensation comes from the cash flows the companies generate from their risky investments via earnings and dividends.

The two other ways to make money from owning an equity asset class are from multiple (P/E) or margin expansion (collectively we call these elements the valuation components). Together these four components make an identity – we can (ex post) always decompose returns into these factors.

In Exhibit 1, we show a return decomposition for the S&P 500 since 1970 based on these four factors (earnings, dividends, margins, and P/Es). Margins and P/Es are basically flat over this very long time period. As we stated above, over the long term, the returns achieved have been delivered largely by dividends.