February 2, 2025 —
The DeepSeek blip notwithstanding (our initial take on the news is here), January 2025 was a good month for financial markets. The S&P 500 was up a robust 2.7%, though Nasdaq lagged (largely due to DeepSeek, in our opinion) with “only” a 1.7% monthly return. Leading the charge were gold and bitcoin, while the dollar took a respite from its own recent breakneck pace of appreciation. Value and momentum both did well in January, and some recent sector themes—financials, communications, utilities—continued to provide market leadership.
Most surprisingly, for the first time in a while, international stocks outperformed their U.S. counterparts. Perhaps DeepSeek again played a role as international markets cheered technological developments coming from someplace other than the U.S. (despite fears that some of this progress was plagiarized). Even bonds didn’t have a down month, which is unusual given recent price action.
QuantStreet had a pretty good month in January 2025, moving largely in line with our asset allocation mutual fund benchmarks. The in-line move breaks a recent streak of QuantStreet outperformance, which has been largely on the back of our U.S. overweight relative to the mutual fund benchmarks’ much heavier international equity allocation (often between 30-40% of the overall portfolio). You can read more about our performance results here.
Our view is that the valuation gap between U.S. and international markets has grown so wide—more on this below—that it now makes sense to allocate a bit more internationally. Unfortunately, international stocks look very unattractive based on our tactical model and trend-based signal. The reason is that valuation gaps are not important determinants of one-year ahead stock returns, which is the horizon we use in our asset allocation process. Despite this, we initiate a small allocation to international stocks in the coming month on the back of a longer-horizon analysis (see below). If the short-term tactical signal becomes more aligned with the longer-term one, we will add to the international exposure of the portfolio.
U.S. versus International
U.S. stocks have outperformed their international peers over the last several decades. The next chart shows the degree of this outperformance in just the last 10 years.
Part of the outperformance has been higher earnings growth in the U.S., which is likely sustainable going forward because of structural reasons (faster economic growth, more pro-shareholder culture, rule of law, technological innovations, greater share buybacks, etc.). But part of the outperformance has been a growing gap in price-to-earnings ratios (as well as in price-to-forward-earnings ratios) and dividend yields.
This valuation and dividend yield gap is now so large that for U.S. outperformance to continue an ever-greater burden is being placed on the U.S. earnings growth advantage. In a recent piece we show that if price-to-earnings (P/E) ratios and dividend yields revert to their medians over the last two decades and if earnings growth equals its 20-year average, U.S. stock returns will lag those of international peers by several percent per year over the next 10 years. The next table shows the anticipated annual returns of different stock markets in this return-to-median scenario: U.S. stocks will return a paltry 4.5% per year, while European stocks (SXXP) will return over 8.5%.
Key to table: SPX = U.S.; SXXP = Europe; MXAP = Asia; MXWOU = International ex-U.S.; MXEF = Emerging markets; NKY = Japan; NDEUSIA = India
Scenario analysis shows that if U.S. P/E ratios mean-revert a bit—but not all the way back to their historical median level—and if U.S. earnings over the next 10 years are truly stellar, U.S. stocks can still be the global leader. But the valuation and dividend yield gaps are so large that the earnings growth bar is very high. For a more detailed analysis, consult our recent piece on this topic.
For our part, we will be watching carefully how the U.S.-international valuation gap continues to evolve. Should the tactical and valuation signals align, we will allocate a larger portion of the portfolio internationally.
Working with QuantStreet
QuantStreet is a registered investment advisor. It offers wealth planning, separately managed accounts, model portfolios and portfolio analytics, as well as consulting services. The firm’s approach is systematic and data-driven, and also shaped by years of investing experience. To work with or learn more about QuantStreet, join our mailing list or contact us at hello@quantstreetcapital.com.
Cover picture generated by Gemini.