U.S. Stocks Are Super-Expensive, But for the Right Reasons

There are two beautifully simple explanations for why U.S. stocks are valued so much higher than equities in the rest of the developed world. First, the U.S. economy is doing much better than troubled Europe, aging Japan or Brexit-stricken Britain. Second, the U.S. market includes the FANGs of Facebook , Amazon.com , Netflix and Google, now Alphabet, while the rest of the developed world has few big companies with high growth potential.

The question investors often ask is whether the valuation gap is so big they should prepare for a reverse. I don’t think the U.S. premium is mostly speculative, or down to an irrational desire to buy American. It is based on better economic fundamentals and a core of strong companies. Concerns should focus on threats to one or the other.

Two of those concerns are whether it is politically sustainable for the U.S. to host so many of the companies disrupting business elsewhere, and whether big U.S. companies really benefit enough from faster U.S. growth to justify such a big premium.

Examining the valuation gap itself will show it isn’t quite what it seems. It also helps assuage a third worry, that the market is treating U.S.-based multinationals as though they are radically different to multinationals based in London, Paris or Tokyo.

The premium on the price-to-book multiple for U.S. stocks above those elsewhere is the highest since the 2001 recession wiped out the remnants of the dot-com valuations. Aside from the dot-com bubble period, the U.S. has the biggest price-to-book premium over the eurozone, U.K., Japan and emerging markets since at least 1980, according to Refinitiv data.

Comparing prices to 12-month-forward earnings estimates for MSCI indexes the situation is perhaps even more extreme, with the U.S. at 17.4 times earnings, the eurozone at 13.3 times, Japan 12.9 times and the U.K. 12 times. In all cases this is at or close to the biggest premium in data since the 1980s.

Drill down and this is the result of the U.S. having a higher valuation than the eurozone, U.K. or Japan in six of the 10 high-level economic sectors (excluding real estate, which is hard to compare). It isn’t the cheapest in any sector.

Even where the U.S. lags behind—technology stocks are more expensive in the eurozone, industrial stocks in the U.K. and health-care stocks in Japan—the sheer size of the higher-value sectors in the U.S. helps boost the overall premium.

Should U.S.-based multinationals trade at a premium just because they are based or listed in America? Aside from some corporate governance issues, I’d argue not. And it looks like the market agrees, sensibly valuing U.S. multinationals with poor fundamentals at less than foreign rivals. In other words, investors don’t blindly buy American for the sake of it.

In Detroit, car companies have grown used to people no longer buying American: They are having a tough time, and trade at a discount to better brands in Japan and Germany (themselves cheap compared with history thanks to a dismal outlook for the global industry).

The consumer staples sector provides further examples, with U.S. multinational drinks or toothpaste companies valued similarly to those elsewhere. The slight discount of the U.S. sector to the eurozone comes in large part from the lowly-valued tobacco companies Philip Morris International and Altria .

Political opposition to the FANGs and other big disruptive U.S. companies is more serious. Domestically their dominance of new industries has rightly created competition concerns. Internationally they have become politically toxic thanks to tax avoidance combined with being foreign monopolies. It’s far too soon to conclude that either is an existential threat, but they should have a lower valuation than they otherwise would to reflect the risk of profit-damaging regulatory action.

The economy also matters. It clearly helps to be American when America’s economy is growing faster. Morgan Stanley estimated earlier this year that 69% of U.S.-listed company revenue comes from the U.S., against less than 20% from the U.S. for European and Japanese stocks.

But this cuts both ways. European and Japanese stocks have much more revenue from emerging markets, and in many ways are more exposed to global growth. If the world economy picks up, they should benefit more. For now investors don’t think it will, but economic forecasting is, shall we say, inexact.

There is no single answer to the question of whether the valuation gap is too big, because only part of it comes from assumptions about faster U.S. growth. But the bigger it is, the more investors in U.S. stocks should be focused on the threats both to U.S. economic leadership and to the growing dominance of American tech giants.