Why Australian stocks should outperform US stocks in the years ahead

US stocks have well and truly dominated Australian stocks since the bottom of the market in 2009, with the S&P 500 up nearly 200% and the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) up around 60%. However, in my view, the Australian market has a good chance of outperforming over the coming decade.

It may seem counterintuitive, but long-term market returns are typically easier to estimate than short-term returns. This is due to the volatile and random nature of markets over shorter periods.

The legendary pioneer of index investing, Jack Bogle, recently estimated a return for US stocks of around 2% per annum for the next decade. The estimate is based on his simple formula:

Returns = Dividend yield + Earnings growth + change in valuation

The US market has a dividend yield of around 2%. This means that Bogle expects that any earnings growth will be offset by a return of valuations to more normal levels.

Research Affiliates provides estimates for 10-year returns using a similar model. They expect the S&P 500 to return 1.1% per year (after inflation) on the basis that the Shiller P/E is currently at 27, significantly higher than its historical median of 16.

US shiller PE


The Shiller P/E is a modified version of the P/E ratio that uses 10 years of earnings and adjusts for inflation. No indicator is perfect, however, research suggests that countries which are cheaper based on the Shiller P/E generally outperform on average for the next decade.

By comparison, the Shiller P/E for Australian stocks is at 15, slightly below its historical median of 16.

Research Affiliates estimates real returns of 6.1% per annum for Australian stocks on the basis of the dividend yield (4.7%), growth estimate (1.3%) and a slight valuation boost (nominal returns would be 2%-3% higher, depending on inflation).

With the added benefit of franking credits for Australian investors, this is quite reasonable in my view.

It is worth remembering that these valuation metrics are largely determined by the biggest companies in the underlying index – i.e, the major banks like Commonwealth Bank of Australia (ASX: CBA) and miners like BHP Billiton Limited (ASX: BHP). Future returns for the broad indices will continue to be influenced by these companies.

Buffett’s Model

Another metric worth considering is what Warren Buffett described as “probably the best single measure of where valuations are at any given moment”.

Buffett’s indicator compares the total market capitalisation (TMC) of stocks to the gross domestic product (GDP) of the economy within the context of its long run average.

Since Buffett first described it in 1999, it has proven to be a useful way for investors to gauge when to be greedy and when to be fearful.

The following chart shows that the ratio for the US market is currently quite high relative to its history.

US buffett ratio


While still well below the levels of the 1999 tech bubble, it is now well above its 2007 heights.

By comparison, the ratio for Australian stocks is far more reasonable relative to its prior levels.

australian buffett ratio 2


After an impressive 25-year run of GDP growth, the Buffett model suggests that if Australia can continue growing its GDP, sooner or later, stocks will follow.

How 1 Man Made 100x His Money After 50

Few know, that as Warren Buffett blew out the candles on his 50th birthday cake, he had just 1% of his current fortune. Think about it: At an age when most give up hope, Buffett was just getting started on the remaining 99% of his fortune. Goes to show you that it's never too late for you to potentially get rich.

Which is why we've gathered the strategies we learned from Buffett, distilled them down to 11 simple lessons, and put it in an exclusive report for you to claim. Just click here to learn more about this handy investing guide.

Motley Fool contributor Matthew Bugden has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

Two New Stock Picks Every Month!

Not to alarm you, but you’re about to miss a very important event! Chief Investment Advisor Scott Phillips and his team at Motley Fool Share Advisor are about to reveal their latest official stock recommendation. The premium “buy alert” will be unveiled to members and you can be among the first to act on the tip.

Don’t let this opportunity pass you by – this is your chance to get in early!

Simply enter your email now to find out how you can get instant access.

By clicking this button, you agree to our Terms of Service and Privacy Policy. We will use your email address only to keep you informed about updates to our website and about other products and services we think might interest you. You can unsubscribe from Take Stock at anytime. Please refer to our Financial Services Guide (FSG) for more information.