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After a rocky start to the year, U.S. stocks have recovered and enjoyed excellent year-to-date returns. The S&P 500 is up some 16% YTD while the Nasdaq Composite has surged about 21% and the all-cap Russell 3000 has returned about 15%.

While those are strong results, international stocks have outperformed their U.S. counterparts this year.

The broad FTSE Global All-Cap Ex US index has returned roughly 28% YTD and the leading indexes in Europe, Asia, and Emerging Markets have all outperformed U.S. stock as well. Specifically, the MSCI Europe index is up 29%, the MSCI AC Asia Pacific index is up 28%, and the MSCI Emerging Markets index has returned about 33%.

This is a reversal of what we have seen over the past five and 10 years, as U.S. stocks have significantly outperformed international stocks on an annualized basis.

Many investors are wondering if the recent international outperformance is the start of a new trend, or a short-term blip. Qian Wang, Vanguard’s chief economist for the Asia-Pacific region and the global head of Vanguard Capital Market Research, weighed in recently with her thoughts.

The short answer is yes – although there are some caveats .

Are U.S. stocks in a bubble?

It has been a volatile year for U.S. stocks and there have been many factors contributing to that. But the surge since April lows has raised concerns about sky-high valuations, particularly for tech and AI stocks. Are stocks in an AI-fueled bubble ?

“For a few years now, we’ve emphasized how overvalued U.S. stocks have become. And yet, driven by large tech companies, U.S. stocks continue to hit all-time highs with astonishing regularity. But unlike what we saw in the dot-com environment more than 25 years ago, U.S. stocks aren’t necessarily in a bubble,” Wang said.

The high-flying tech market leaders are still generating huge profits, she said. In addition, an environment that favors innovation and productivity with less regulation and strong corporate balance sheets can partly justify the high prices – at least in the short-term.

“Despite our more muted long-term return outlook, the combination of continued economic and earnings growth and expected Federal Reserve monetary policy easing to cushion downside risk — almost a Goldilocks scenario — could continue to support U.S. market returns in the near term,” Wang said.

Over the longer term it’s a different story.

Our research shows that over longer periods approaching 10 years or more, valuations act like gravity, eventually pulling returns back toward their historical norms,” Wang said.

Valuations alone typically don’t trigger market corrections, she said. However, they do make stocks more vulnerable to shocks, which, when combined with high valuations, can trigger a correction.

So, things like renewed recession fears, disappointing earnings, higher inflation, slower than expected Fed easing, geopolitical events, or a pullback in AI spending, among others, could pose downside risks with valuations already stretched.

Why U.S. stocks will lag international stocks

Vanguard economists do expect this valuation reversion to be a drag on U.S. stocks over the long term.

Our models indicate a likelihood that U.S. equities will lag non-U.S. stocks over the next decade,” Wang.

However, she said that there is a meaningful chance that U.S. stocks will outperform, with AI as a major tailwind.

“The promise that AI will change how we live has been a major tailwind for the U.S. market. If AI’s full potential is realized, U.S. companies could continue to deliver strong growth,” Wang said.

However, Wang noted that international companies may benefit even more from AI once it is widely applied, commercialized, and integrated into the broader economy.

“There’s “low-hanging fruit” overseas, where AI and automation can drive significant improvements in productivity and efficiency, allowing international companies to catch up to U.S. peers,” Wang said. “On the other hand, if AI fails to deliver as expected, non-U.S. markets would likely have less of a pullback than U.S. markets.”

There are also other factors that could favor international stocks, including increased defense spending and policy shifts that are more supportive of economic growth, among others. In addition, Wang said currency exchange rates may be less of a tailwind for the U.S. market if investors continue to diversify away from USD assets.

Ultimately, she said, diversification is important.

“No one should go “all in” on either U.S. or non-U.S. investments. Instead, investors should be diversified and, for the long term, may want to tilt their portfolios a bit more toward international,” Wang said.

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