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Distinct and Predictable U.S. and ROW Equity Market Cycles?

| | Posted in: Calendar Effects, Technical Trading

A subscriber asked: “Some pundits have noted that U.S. stocks have greatly outperformed foreign stocks in recent years. What does the performance of U.S. stocks vs. foreign stocks over the last N years say about future performance?” To investigate, we use the S&P 500 Index (SP500) as a proxy for the U.S. stock market and the ACWI ex USA Index as a proxy for the rest-of-world (ROW) equity market. We consider three ways to relate U.S. and ROW equity returns:

  1. Lead-lag analysis between U.S. and ROW annual returns to see whether there is some cycle in the relationship.
  2. Multi-year correlations between U.S. and next-period ROW returns, with periods ranging from one to five years.
  3. Sequences of end-of-year high water marks for U.S. and ROW equity markets.

For the first two analyses, we relate the U.S. stock market to itself as a control (to assess whether ROW market behavior is distinct). Using end-of-year levels of the S&P 500 Index and the ACWI ex USA Index during 1987 (limited by the latter) through 2019, we find that:

The following chart tracks SP500 and ROW time series over the sample period with both initial values scaled to 1.00. While the two series mostly rise and fall together, SP500 substantially outperforms ROW with compound annual growth rate (CAGR) 8.5% versus 3.3%.

The next chart summarizes lead-lag relationships between annual S&P 500 Index (SP500) return and ROW annual return over the available sample period, ranging from ROW return leads SP500 return by five years (-5) to SP500 return leads ROW return by five years (5). For reference, it also shows SP500-SP500 autocorrelations for the same leads/lags. Notable points are:

  • The dominant relationship is coincident, with SP500 annual return explaining (based on R-squared statistic) about half the variation in ROW annual return.
  • For most leads and lags, SP500-ROW annual return correlations are negative, suggesting a cumulative reversion effect. However, findings are similar for SP500-SP500 autocorrelations, indicating that the effect is not unique to ROW.

Note that negative correlation does not mean negative return. For example, the correlation of -0.27 at point 1 means that there is some tendency for ROW return to be relatively weak (strong) the year after SP500 return is relatively strong (weak).

What about multi-year return correlations?

The following table summarizes SP500-SP500 autocorrelations and SP500-ROW correlations between independent past and future return intervals ranging from one year to five years. It also shows the sample size for each calculation. Notable points are:

  • SP500-ROW correlations are negative at all horizons, suggesting that ROW multi-year return tends to be relatively weak (strong) after SP500 multi-year return is relatively strong (weak).
  • SP500-SP500 autocorrelations exhibit some, but not all, of this effect.
  • Sample sizes are extremely small for multi-year horizons, such that noise (luck) dominates signal.

Again, negative correlation does not mean negative return.

Do index new highs illuminate?

The final chart shows, via color-coded columns, the years in which SP500 and ROW close at new highs across the available sample period starting at the end of 1988. Notable points are:

  • The two indexes reach new highs together for seven of 30 years, all early in the sample period.
  • SP500 (ROW) reaches a unique high for eight (four) of 30 years.
  • There is no obvious alternating SP500-ROW cycle of new highs.

Again, the sample is very short for assessing multi-year cycles.

In summary, available evidence offers little support for belief that investors can time multi-year differences in returns between U.S. and non-U.S. stocks.

Cautions regarding findings include:

  • As noted, the sample period ranges from short to extremely short for the kinds of analyses performed, undermining confidence in all findings.
  • The selected indexes do not include dividends.
  • Average annual return is so much higher for SP500 than ROW (9.8% versus 5.5%) that even a relatively weak SP500 annual return may exceed the corresponding ROW annual return.

See also “U.S. Equity Premium?”.

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