Chris Leithner

Why Australian equities will again outperform

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Their earnings have sunk since the GFC, yet even weaker bases underpin the S&P 500’s returns. Aussie stocks thus offer better prospects.

Overview

Over the past decade and more, the total (incorporating the reinvestment of dividends) returns of the All Ordinaries and S&P/ASX 200 indexes have underperformed the S&P 500 Index. According to Roger Montgomery, dividends – specifically, Australian companies’ allegedly overly-generous payments, retention of insufficient earnings and restriction of capital expenditure, which, he asserts, cause shareholders’ returns to fall – are to blame (see Dividends do not make a good company – Part 1, 6 November 2023 and “Why the ASX 200 has gone nowhere in 16 years,” Firstlinks, 8 November 2023).

In Dividends Aren’t a Bane – They’re a Boon (20 November 2023), I comprehensively disproved Montgomery’s assertions. Neither in the U.S. nor in Australia are dividends a bane of investment life. Quite the contrary: they’re a boon and bulwark of long-term returns.

Why, then, have Australian shares underperformed? Shane Oliver (Australian shares at new record highs – is it sustainable? 17 July) nominates a range of factors. “The near 15 year period of underperformance since 2009 reflects:

  • “payback for the huge outperformance of the 2000s on the back of the mining boom;
  • the slump in commodity prices from 2011;
  • the lagged impact of the surge in the $A into 2011;
  • relatively tighter monetary policy in Australia for much of the post-GFC period;
  • fear more recently that rate hikes will hit Australia harder due to more indebted households and Australia’s relatively expensive property market;
  • worries about tensions with China and the slowing Chinese economy;
  • and a low exposure to tech stocks – with tech stocks propelling U.S. shares in the pandemic and more recently with AI excitement.”

Most of these points – particularly the last one – seem plausible. Yet Oliver, like Montgomery, asserts rather than analyses: he doesn’t attempt to demonstrate logically that commodity prices, exchange rates, monetary policy, etc., affect Australian equities’ returns; still less does he show empirically that over the past 10-15 years they’ve crimped returns. Accordingly, neither individually nor jointly are his reasons: none, as I’ll demonstrate, digs to the root of Australian equities’ recent underperformance.

That’s partly because they’re Oz-centric; they thereby downplay or ignore key developments in the U.S. Yet posing the question “why have Australian equities underperformed American ones?” is necessarily to ask: “why have American shares outperformed Australian ones?”

Oliver continues: “some of these factors have waned … But some still remain (and they) could still push U.S. and hence global shares up more than Australian shares. So … it is probably too early to be confident that the underperformance is over even though Australian shares offer better medium-term prospects.”

As I’ll also show, in this respect Oliver’s right. Indeed, the All Ordinaries Index’s long-term as well as its medium-term prospects exceed the S&P 500’s. But my explanation differs greatly from Oliver’s.

In this article, I calculate and compare the total returns of the All Ordinaries and Standard & Poor’s 500 indexes over various (including all five- and ten-year) periods over the past 50 years. I uncover four key results:

  1. The total return of one index relative to the other is neither random nor permanent; instead, it’s cyclical.
  2. The duration the All Ords’ current relative underperformance is the longest of the past 50 years; but compared to previous stretches its magnitude is mild.
  3. Following the method devised by John Bogle, I partition these indexes’ total returns into three components – and thereby identify the source of the All Ords’ underperformance and the S&P 500’s outperformance: earnings growth (U.S.) and the lack thereof (Australia).
  4. I also identify and quantify three weak bases of the S&P 500’s outperformance since the GFC: the rising reliance of earnings growth upon share buybacks, and consequently high debt to equity and cyclically-adjusted P/E (“CAPE”) ratios.

In short, since the GFC the All Ords’ total returns have lagged the S&P 500’s mostly because Australian equities’ CPI-adjusted earnings have fallen – and American stocks’ earnings have soared.

Australian equities’ earnings per share (EPS) have lagged partly because debt-financed share buybacks don’t (as they do in the U.S.) underpin them; accordingly, Australian debt-to-equity and CAPE ratios are comparatively low, and over the past 20 years the debt-to-equity ratio has fallen.

Conversely, American stocks’ EPS has zoomed, certainly to a significant degree and perhaps to a considerable extent, because S&P 500 companies have repurchased colossal quantities of their own shares. They’ve also used large amounts of debt to finance the buybacks; as a result, their debt-to-equity and CAPE ratios aren’t merely relatively high: since 2005 they’ve trended upwards.

From these results I draw two fundamental conclusions. Firstly, American equities have generated appreciable rewards since the GFC – but at current prices they also entail considerable risks.

Secondly, Australian equities, not despite but because of their underperformance over the past 10-15 years, aren’t merely more robustly financed; they’re also more conservatively priced and thus offer superior medium- and long-term prospects (see also Why the S&P 500’s five-year prospects are poor, 27 December 2023).

Data

I’ve analysed the data originally compiled by Robert Shiller for his book Irrational Exuberance (Princeton University Press, 1st ed., 2001) and updated regularly since then. Over the periods which I’ve considered (the 50 years since 1974), these include monthly closing levels of the S&P 500 index, Standard & Poor’s monthly calculations of the index’s earnings and dividends, and the U.S. Bureau of Labor Statistics’ quarterly estimates of the Consumer Price Index (which Shiller has extrapolated into monthly data).

I’ve also analysed monthly closes, earnings and dividends of the All Ordinaries Index (obtained from S&P since 2005 and the ASX from 1974 to 2005), as well as the Australian Bureau of Statistics’ quarterly estimates of the Consumer Price Index (which I’ve extrapolated into monthly observations). With these data I’ve replicated Shiller’s method of calculating total CPI-adjusted returns.

Four Intervals over the Past 50 Years

Figure 1 plots the growth on a monthly basis since January 1974, including and assuming the reinvestment of dividends and net of the Consumer Price Index, of investments of $1 in portfolios that mimicked the All Ordinaries and S&P 500 Indexes.

These results ignore taxes, rebalancing-transaction and other costs (which would be considerable); they also exclude the value (which would be appreciable) of Australian franking credits since the commencement of the dividend imputation system 1987.

The portfolio that replicated the All Ordinaries Index grew to $19.80 in June 2024; that’s a compound annual growth rate (CAGR) of 6.1%. Each $1 invested under the same assumptions in a portfolio that’s replicated the S&P 500 grew to $33.73 in June of this year; that’s a CAGR of 7.2%. Over the past half-century, particularly during the Dot Com Bubble and since the GFC, the S&P’s CPI-adjusted total return has outperformed the All Ords’.

Figure 1: CPI-Adjusted Accumulation of Capital per $1 Invested, All Ordinaries and S&P 500, Monthly, January 1974-June 2024

Figure 2 plots these series since January 2000. Each $1 invested during that month in a portfolio that’s mimicked the All Ordinaries Index grew to $3.48 in June 2024; that’s a CAGR) of 5.2%. Each $1 invested in a portfolio that’s replicated the S&P 500 grew to $3.19 in June 2024; that’s a CAGR of 4.9%.

Since the turn of the century, the All Ords’ CPI-adjusted total return has slightly but continuously outperformed the S&P 500’s.

Figure 2: CPI-Adjusted Accumulation of Capital per $1 Invested, All Ordinaries and S&P 500, Monthly, January 2000-June 2024

From the mid-1970s until the late-1990s, the two investments compounded virtually in tandem. During the Dot Com Bubble of the late-1990s, the S&P 500 greatly outperformed the All Ords. But then the bubble burst and Australia’s mining boom occurred; as a result, for almost a decade (a period which included the Global Financial Crisis) the All Ords outpaced the S&P 500.

Since 2011, however, the American index’s total return has exceeded its Australian counterpart’s. Since then, and particularly since 2020, Australian equities have significantly underperformed their very long term (since 1974 and 2000) averages (Figure 3); if their returns subsequently revert to these long-term means (which, I’ll show below, is reasonable to expect), then their CAGRs will rise.

In contrast, since the GFC American stocks have greatly outperformed their long-term averages; unless their returns permanently exceed 9% per year, which I strongly doubt, during the years to come they’ll recede towards their long-term means – which since 2020 has seemingly begun to occur.

Figure 3: CPI-Adjusted Total Returns (CAGRs), All Ordinaries and S&P 500, Four Intervals to June 2024

All Five- and Ten Year Intervals over the Past 50 Years

How do Australian and American equities’ rolling five-year and ten-year CAGRs compare? From January 1974 to January 1979, the All Ordinaries Index’s CPI-adjusted CAGR was -2.54% and the S&P 500’s was -2.47%. The Australian index thus underperformed its American counterpart by -2.54% – (-2.47%) = -0.07%. Percentages below 0% thus denote underperformance and percentages above 0% indicate outperformance. I repeated this exercise for all subsequent five-year CAGRs (February 1974-February 1979, … June 2019-June 2024) as well as all ten-year CAGRs; Figure 4 plots the results.

Figure 4: Performance of the All Ordinaries Relative to the S&P 500 (CPI-Adjusted Total Returns (CAGRs)), Monthly, January 1984-June 2024

Four results from the five-year series are most noteworthy:

  1. The performance of one index relative to the other is neither random nor permanent; instead, it’s cyclical.
  2. The All Ords outperformed from May 1979 to August 1984, March 1987 to May 1989 and January 2002 to March 2011.
  3. The S&P 500 outperformed from September 1984 to February 1987, December 1988 to December 1993, April 1996 to August 2001 and since November 2011.
  4. The duration All Ords’ current underperformance vis-à-vis the S&P 500, which exceeds 10 years, is the longest of the past 50 years; but compared to previous stretches (which averaged -6.5%, exceeded -10% and approached -15%) its magnitude (average of -4.6% and maximum of -9.4%) is comparatively mild.

The Source of the All Ords’ Cyclical Underperformance

John Bogle, in his book The Little Book of Common Sense Investing (John Wiley & Sons, revised and updated 10th anniversary ed., 2017), emphasises “the remarkable, if essential, linkage between the cumulative long-term returns earned by U.S. business – the annual dividend yield plus the annual rate of earnings growth – and the cumulative returns earned by the stock market …” (p. 10).

He divides stocks’ returns into three parts: “(1) investment return (enterprise), consisting of (a) the initial dividend yield on stocks plus (b) their subsequent earnings growth (together, they form the essence of what we call ‘intrinsic value’) and (2) speculative return, the impact of changing price/earnings multiples on stock prices” (p. 15).

“Look,” he says, “at the record since the beginning of the 20th century. The average annual total return on stocks was 9.5%. The investment return alone was 9.0% – 4.4% from dividend yield and 4.6% from earnings growth.” The difference between the total return and the investment return “of 0.5% per year arose from … speculative return. (It) may be a plus or a minus, depending on the willingness of investors to pay either higher or lower prices for each $1 of earnings at the end of a given period than at the beginning” (pp. 10-11).

What underpins the speculative return? “The price/earnings (P/E) ratio measures the number of dollars investors are willing to pay for each $1 of earnings. As investor confidence waxes and wanes, P/E multiples rise and fall.” Bogle acknowledges that changes of interest rates affect the market’s P/E.

Whether it’s rates or some other reason, “when greed holds sway, very high P/Es (and positive speculative returns) are likely … When fear is in the saddle, P/Es are typically very low (and speculative returns become negative)” (p. 11).

Speculative returns – positive and negative – punctuate some periods more than others: “to be sure, stock market returns sometimes get well ahead of business fundamentals … But it has only been a matter of time until, as if drawn by a magnet, they ultimately return to the long-term norm, although often only after falling well behind for a time, as in the mid-1940s, the late-1970s and the 2003 market lows. It’s called reversion (or regression) to the mean” (p. 13).

“In our foolish focus on the short-term stock market distractions of the moment,” warns Bogle, “investors often overlook this long history. When the returns on stocks depart materially from the long-term norm, we ignore the reality that it is rarely because of the economics of investing – the earnings growth and dividend yields of our corporations. Rather, the reason that annual stock returns are so volatile is largely because of the emotions of investing, reflected in those changing P/E ratios” (pp. 13-14).

He doesn’t stop there: “while the prices we pay for stocks often lose touch with the reality of corporate (profits and dividends), in the long run reality rules. So, while investors seem to intuitively accept that the past is inevitably prologue to the future, any past stock market returns that have included a high speculative stock return component are deeply flawed guides to what lies ahead” (p. 14; italics in the original).

In Index funds’ key flaws – and how we overcome them (23 October 2023) I replicated Bogle’s approach but improved his method: rather than disaggregate one-year results into their three components, I partitioned the S&P 500’s five-year CAGRs into their three components. In that article, I analysed the S&P 500’s return over various intervals from 1871 to 2023; here, I compare the All Ordinaries and S&P 500’s returns over key intervals from 1974 to 2024. Figure 5 summarises the American results.

Figure 5: Components of the S&P 500’s Average, Five-Year, CPI-Adjusted Total CAGR, Four Intervals since 1974

As time has passed, the average five-year total CAGR has varied; so too have its components. Most significantly, during each period earnings are by far the biggest contributor; dividends contribute a much smaller portion, and the CAGR’s speculative component – changes of the P/E ratio – is the most variable.

Moreover, since 2000 the increase of the speculative component has contributed an ever greater portion of the total return.

Figure 6 summarises the Australian results. As in the U.S., so in Oz: over time the All Ords’ average five-year total CAGR has varied; so have its components. In particular, the speculative component has contributed an ever-greater share of the total return.

Figure 6: Components of the All Ordinaries’ Average, Five-Year, CPI-Adjusted Total CAGR, Four Intervals since 1974

Yet the compositions and changes in the two countries differ fundamentally. In the U.S., dividends are a constant but minor contributor to total returns; in Australia, they’ve been a major and the most consistent contributor.

Why, particularly since the GFC, has the All Ords underperformed the S&P 500? One key reason is that earnings haven’t contributed to its total return. Quite the contrary, they’ve crimped it – either marginally (since 2009) or significantly (by three percentage points since 2020).

Causes of the All Ords’ Cyclical Underperformance

Over the past half-century, the All Ordinaries Index’s total return has underperformed the S&P 500 Index’s. Since the turn of the century, however, the All Ords has marginally outperformed the S&P 500. Over shorter intervals, the Ords’ relative total return has been cyclical: at some points since 1975, it’s markedly underperformed, and at others it’s significantly underperformed. In particular, its continuous but modest underperformance since 2011 is the longest since 1975.

Why since the GFC have Australian equities underperformed? Unlike in the U.S., where earnings have continuously been the biggest contributor to the S&P 500’s total return, in Australia since the GFC earnings have crimped the All Ords’ total return. Figure 7, which plots each index’s CPI-adjusted earnings, substantiates this sharp discrepancy. In order to render the two series comparable, I’ve rescaled each with an identical origin ($1.00). Net of CPI, the S&P’s earnings grew to $3.37 in June 2024; that’s a CAGR of 5.2%. In sharp contrast, the All Ords’ shrank to $0.84; that’s a CAGR of -0.5%.

Figure 7: CPI-Adjusted Earnings, All Ordinaries and S&P 500 Indexes (January 1974 = $1.00), January 1974-June 2024