At the start of this month, the US market dropped by 6%, and Australia followed suit with an identical decline. In the week after, the US rebounded by 3%, whilst Australia only managed a 2% recovery.
This situation got me thinking: why does it seem like the Australian share market consistently underperforms compared to international markets? And is there a chance this will ever change?
Looking back at history
It’s easy to let recent experiences shape our views, but when it comes to investing, adopting a long-term perspective is critical, especially if you plan to stay invested for the long haul.
The chart below compares the returns from the Australian share market with international returns in Australian dollars over the past 40 years. You might be surprised that the difference in annualised returns is quite minor over this 40-year period. The Australian market has delivered a return of 10.3% p.a., only slightly below international markets at 10.7% p.a.
However, in recent years, the returns have varied quite a bit. Since early 2013, international markets have outperformed, largely driven by the US market, which now accounts for over 71% of the global index.
For example, $100 invested in the Australian share market at the start of 2013 would have grown to $255 by the end of 2023. In comparison, the same $100 invested in the international index would have increased to $465.
What has contributed to the return differential?
Information technology has been the biggest driver of growth in international indexes over the past decade. This sector now makes up a quarter of the global index, compared to just over 13% a decade ago.
However, the concentration risk is even more concerning. The so-called “Magnificent 7” stocks now represent over 21% of the global index and more than 30% of the US index. Their market capitalisations have surged massively over the last decade.
While technology has undeniably been a major economic contributor, it’s unlikely this stock market trend will continue at the same pace in the next decade. Much of the anticipated future growth seems to be already priced into these stocks since they are trading at an average forward PE ratio of between 30 and 40 times – which is double the market’s long-term average. To achieve returns, investors will need these stocks to outperform the already lofty growth expectations.
It’s tempting to assume that today’s tech giants will keep dominating stock indexes, but history shows that the top companies can change a lot from decade to decade. For example, back in the year 2000, during the tech bubble, Cisco Systems was valued at half a trillion dollars and was expected to become the world’s first trillion-dollar company. Today, its value is around $180 billion.
What returns can we expect in the future?
Global investment research firm, Research Affiliates publishes extensive peer-reviewed research and data. One of its tools uses evidence-based methodologies to forecast future stock market returns. This model considers factors like dividend yield, profit growth, and valuation multiples to project investment returns. While these are just predictions and actual results may vary, the models have shown a strong correlation with future returns and are currently the most reliable indicators we have. The chart below outlines the projected future returns for Australian investors.
It is very clear from the above forecasts that large-cap stocks in the US will likely be the biggest drag on international investment returns over the next decade. If you agree with this analysis, your international investments should be structured to accommodate this risk.
The Australian market may be a top performer
It’s worth noting that the Australian stock market is projected to deliver strong investment returns over the next decade. The expected return of 7.9% per annum is broken down into 3.9% from dividend yield + 2.5% from inflation + 2% from growth -0.5% adjustment for valuation change.
Note that this forecast includes a slight drag of -0.5% p.a. due to valuation, indicating that the Australian share market may be currently slightly overvalued.
One of the key aspects of this forecast is the dividend yield of 3.9% p.a. For ETF investors, the current cash dividend yield is 3.5-3.6% p.a. However, when factoring in imputation credits, the pre-tax dividend yield rises to 4.7-4.8% p.a., using ETFs like A200 and IOZ as examples.
A higher income return helps reduce investment risk, as it means you rely less on future growth to meet your investment return goals.
Sidebar: Japan is expected to produce a strong return of 8.2% p.a. 2% p.a. is projected to be driven by currency fluctuations i.e., Yen versus the Australian dollar. However, Japan faces challenges, including its prolonged reliance on zero interest rates. While I’m open to having exposure to the Japanese market, I prefer not to over-weight it, despite the higher return forecast.
The Australian index is likely to beat the global index over the next decade
While Australian investors haven’t enjoyed the strong returns that international investments have delivered over the past decade, this trend is likely to reverse over the next decade. However, this doesn’t mean Australian investors should disregard international markets. On the contrary, neglecting international markets can be costly in the long run.
The Australian share market makes up only about 2% of global developed markets and is heavily weighted towards miners and banks. Without sufficient exposure to international markets, you miss out on opportunities in a wide range of growth sectors. If you do choose to invest internationally, be mindful of how large-cap US stocks might influence future returns.
