The Australian share market has gotten off to a great start this year. Indeed the last 12 months have been fantastic. If you’ve been following along via the gaining choice email you will know that over the last 12 months, investors in the Australian market have gained around 11% inclusive of dividends whilst those investing in the US market are down about 6.5%, again inclusive of dividends.
The ASX’s outperformance is a distinct break from what we’ve seen over the last decade or more. What’s going on and will it continue? That’s what we’ll be discussing in today’s episode.
What are the ASX200 and S&P500
In this episode we’re comparing the Australian stock market with the US stock market. To do this we are considering the indexes commonly used to reflect these markets. An index is a mix of different companies and in the case of the two indexes that we’re looking at, they are weighted according to the size of the company. The ASX 200 index represents the 200 largest companies listed on the Australian Stock Exchange. BHP, being the largest of Australia’s companies, is therefore the largest constituent in the ASX200, representing approximately 11% of the index. The next largest is Commonwealth Bank followed by CSL.
Whilst our index contains 200 companies, in reality it is largely driven by the top 10 which make up almost half the value of the index, 47% to be precise. The bottom 100 companies are all quite small in the index and so have minimal impact. There are some providers who use the ASX300, Vanguard being the most notable. Given the concentration of our market, appreciate that adding these extra 100 smaller stocks makes almost no difference to the outcome.
The US S&P 500 index, tracks the 500 largest companies traded on U.S. stock markets. Here Apple is the biggest company, followed by Microsoft, than Amazon, though Amazon is half the size of Microsoft. The US market is far more diverse than our market. These large companies make up a far smaller proportion of their index. Apple is about 6.5% of the index, Microsoft 5.5%, and the top 10 make up 25% of the S&P500 index. It’s still pretty concentrated, but far less so then our market.
So how have the two markets performed for investors over recent times?
As at 8/2/2023:
|1 year return
|5 years (pa)
Very important to note here that I’m using the accumulation indexes which is to say the index that records both the capital growth and also dividends. Including the dividends is incredibly important when comparing those two markets something will dig into a little bit later. But just be aware that generally when you hear these indexes quoted on the radio or in the news, they are not the accumulation indexes and therefore don’t include dividends. It’s unfortunate that this is the case because it can provide a misleading view.
For longer term numbers, from Vanguard I was able to get the 30 year return numbers until the end of the last financial year, so 30 June 2022. Over that period the average return for Australian shares inclusive of dividends was 9.8% per year, whereas for US shares it was 11.7%.
These numbers all highlight that the last 12 months, where the Australian market has significantly outperformed the US market, is notable. For most of recent history the opposite has been the case with the US market providing investors with a better overall result.
One key difference of the Australian and US markets is the industry composition within each. The largest sector on the ASX200 is financial services, comprising 27% of the index, with our big 5 banks being the main players here. The second largest sector is basic materials at 20% of the index. This picks up BHP, Rio Tinto, and Fortescue. So those two sectors, financials and materials, make up 47% of the index. Therefore, an investor in the ASX200 needs to have a positive view on banking and mining. Indeed for foreign investors, the desire to gain exposure to these two sectors is likely to be the key reason for investing here.
Over on the US S&P 500 index, information technology is the biggest sector at 27% of the index, coincidentally exactly the same weighting as Australia’s largest sector. From here it’s more diverse though. Healthcare makes up 14% of the index financials 11%, then consumer discretionary around 10%. Investors in the US market then, would want to have a positive outlook on the technology and software sector, but beyond this, recognise that they’re getting a fairly diverse exposure to the US economy.
Income vs Growth
Okay, now you’ve got your head around what each of these indexes are, let’s dig into the most important distinction between the two, income versus growth.
Shares produce income via dividends. Most companies payout dividends every six months. We therefore think about the income production of a given share investment in terms of its dividend yield. At present the ASX200 has a dividend yield of approximately 6.3%. That is higher than normal, however throughout most of my 20 year plus career, it’s tended to be somewhere north of 4%.
The US S&P 500 index by comparison is currently running at a yield of just 1.7%.
Now at first blush you would think that the Australian market must be a far better investment, producing well over double the amount of income that it’s US cousin has thrown off. But of course our return as investors is the combination of capital growth plus income. As noted in the historical data earlier, it is the case that although this year is an exception, in recent history it has been the case that an investment in the US S&P 500 index has provided a higher return when compared to the ASX200. This tells you then that although the S&P 500 index doesn’t produce much income, it does produce a lot of growth. So why is it that the US index has such a strong growth bias whereas our local market has far more of an income bias?
The answer is largely about taxes. Here in Australia we have the wonderful system of franking credits, a system that to my knowledge exists nowhere else in the world. If you scroll back in the podcast episodes to November, I had an episode called What are Franking Credits and how do they work that you might like to listen to, to understand this system better.
The key thing is that due to our unusual franking credit regime, investors favour receiving income over capital growth and companies therefore respond to this preference by distributing high levels of their profit out as dividends.
In the United States, there is no franking credit system. Dividends therefore are not highly sought after by investors. Their tax system instead favours capital growth. In response to this, companies are pretty meagre when it comes to dividend payouts, and instead use profits to do share buybacks. This is the process of the company going onto the share market, buying shares in their own business, and then cancelling those shares. It means that there are now fewer shares in the system, which means that each of the remaining shares are worth a little more.
As a somewhat extreme example, the third largest company on the S&P 500 is Amazon and it has never once paid a dividend.
This key difference between the two markets is something that Australian investors should be aware of. For those of us with low personal tax rates, most particularly retirees, the franking credit regime is very very generous, and so there might be some justifiable logic to having a bias towards Australian shares to take advantage of this system. In contrast, those with high personal tax rates, while still receiving the franking credits, get less of a benefit, and would likely therefore have a preference for capital growth where they can be selective around the timing of triggering any capital gains tax assessment to get the most favourable tax outcome.
What’s happening now?
Why has the Aussie market outperformed so significantly over the past year? Here’s a few explanations.
For one, the IT sector in the US had quite high valuations in recent years due to the stunning and consistent rates of growth they produced. Throughout much of 2022, especially the first half of the year, markets were driven by the fear of a recession in 2023 as a result of high interest rates. High valued companies got hit the most in this environment. They had the greatest scope for a fall. And this affected the US market darlings especially.
It’s also the case that whilst both countries face the same problem of high inflation and therefore rising interest rates, Australia’s experience through past periods of global economic slowdown, as is expected to be the case in 2023, is that we tend to fare pretty well. In particular, demand for our resources, such as iron ore, tends to rise during these periods, as governments look to make infrastructure investments to maintain employment and economic activity. Indeed during the 2008 GFC period, Australia was one of the few economies to avoid a recession.
Part of the explanation then for the Australian market performing so well relative to the US market, was that whereas investors began pricing in a very high likelihood of a recession in the United States, it was generally expected that Australia would either avoid a recession, or if there was a recession, it would be very mild by comparison.
The sector differences also have an important role to play here. As touched on earlier, our two largest sectors are financial services and materials. Financial services mainly means banks, though it does include insurers and a few other players as well. With respect to banks, it’s easier for them to make profit margin when interest rates are higher. In that context recent years of extremely low rates have not been helpful for them, but as that cycle has now turned, there is an expectation that banks will be able to grow profits and therefore furnish investors with ongoing, attractive dividends. On top of this, as already touched on, there’s good reason to be positive on the resource sector in a global environment of economic slowdown. So there is some positive tailwinds for the two biggest sectors of our market, and as you will recall, those two sectors make up almost half of our index, so when things are positive here, it’s quite difficult for our local index to have a bad time of it.
Our local ASX200 index, and the US S&P 500 index, are quite different in a number of respects. Most investors would have some exposure to each. It’s important to recognise however that depending on your particular goals and objectives, the proportion that you would allocate between these two options is likely to be different. If income is your main goal and especially if you’re a low tax payer, then you’re likely to lean more towards the local Australian index. For those more interested in growth, a bias towards the US index is likely to be more appropriate. In both cases it’s essential to be a long term investor because as we’ve seen over the past 12 months, performance in any single year can vary quite enormously.
As always I should caution that these comments should in no way be taken as advice, given they have been made without any context as to your particular financial circumstances. If you need help with your investing, you should seek professional financial planning advice. And if you’re in the market for advice, consider our services, details of which can be found on the Advice page of the Financial Autonomy website.Back to All News