February 18, 2026:
It is a feature of financial markets that trends often overshoot. Most trends start for good economic reasons, and many fade once prices come to reflect the new reality. But some take on a life of their own. Investors start to believe that the trend is the new reality of markets, and they rationalize its continuation long after the initial catalysts have been priced in. Increased confidence fuels investment, which strengthens the trend, which further boosts confidence. This flywheel effect can push prices far beyond what the underlying economics justify, and for quite a long time. But eventually, the gap becomes too wide to sustain, prices begin to adjust, and the whole process can start to run in the other direction.
The US exceptionalism trade goes into reverse
It’s been our view that this process was playing out with the valuation premium accorded to US stocks. This trend was fundamentally justifiable at its start, but it eventually morphed into a self-reinforcing ascent to record extremes. By the beginning of 2025, the consensus seemed pretty firmly in favor of the “US exceptionalism” trade: the US economy and stock market would outperform forever, and there was no point in owning anything else.
The main flaw in this view was that US stocks were no longer being driven by superior US earnings growth by that point. Over the prior 5 years, virtually all US outperformance had come from a stronger dollar and rising valuations — and none from faster US earnings growth. 1
The dollar, by then unusually expensive, looked unlikely to continue appreciating as it had.2 It seemed even less likely that relative valuations would stage a repeat performance. In an article posted in early 2025, we noted that US stocks were trading at an unprecedented 70% premium to international stocks. We believed this valuation gap was hard to justify, and more likely to narrow than to widen indefinitely.
It was around that time that the US exceptionalism trend finally turned. International stocks have outperformed the US by 27% in US dollar terms since we sent posted that article.3 (International value stocks, which we favor, did quite a bit better — we’ll discuss them in the next section).
After such a move, it’s reasonable to question whether there is further scope for international outperformance. We believe there is, because this is how long, self-reinforcing trends tend to unwind. Have a look at this chart of US and international stock valuations:
Even after last year’s relative surge in international stocks, US stocks are still quite richly priced in comparison. The trend went very far in one direction; it will take a fairly dramatic opposing move if this relationship is to get back to normal. Nothing moves in a straight line, but over the longer term we suspect that the unwinding of the US exceptionalism trade has more to go.
Value makes a move internationally
Another trend we felt had overshot was that of growth versus value stocks. (This is basically a shorthand for higher-valuation stocks that are expected to grow their earnings quickly, versus lower-valuation stocks that are expected to grow more slowly). Again, what began as a fundamentally valid move grew too far, with the result that growth stocks became exceptionally expensive compared to their value counterparts.
Value stocks have actually made an epic comeback in recent years — you just wouldn’t know it looking at the US. Over the past 5 years, US value and growth stocks performed pretty similarly to one another, with value beating growth by 1.5%/year or about 8% in total. Over that same period, international developed markets value outperformed growth by 11.2%/year or 70% in total!4
The initial valuation mismatch five years ago was so large that even now, we still prefer value stocks in our international allocation. In the US, where that big unwind never really happened, we prefer value stocks even more. 5 They’ve outperformed pretty well this year, but not enough to significantly close the valuation gap that had emerged previously. We view US value stock outperformance as another trend with room to run.
Investment outlook
The capitalization-weighted stock market, with its heavy tilt towards expensive US large cap growth, is not very appealing to us. Its high valuation suggests lower potential returns, and a higher risk of a “lost decade”-type decline if values revert to normal levels. Fortunately, there are many areas of the global stock markets that appear attractively priced: US value stocks, international developed and emerging stocks (especially on the value side), and developed small cap value stocks (with Japanese small caps looking particularly cheap). Our diversified stock strategy is focused on those areas, and we believe it offers prospective returns in line with historic norms for the stock market.
There are good investment options outside of stocks as well. Bonds underwent their own dramatic trends in both directions a few years back. Now bonds have stabilized, and they are priced at perfectly reasonable levels where we’re happy to own them for our less aggressive accounts. We also continue to like liquid alternatives, which can benefit from high cash rates and unusually wide valuation disparities within and across asset classes.
The trends we’ve discussed here translated into a really good year for us last year, and a nice start to this year as well. We don’t know if this will continue in the near term, but we don’t think that matters too much in any case. Our focus is on multi-year returns and on that front, for those willing to cast a wide net, we see a lot to like.
- For US investors holding unhedged foreign stocks, exchange-rate movements affect total returns. The earnings growth stats come from GMO.
- The dollar’s real effective exchange rate, a measure of how expensive it is relative to other currencies, was at a multi-decade high.
- Source: Koyfin; tickers SPY, VXUS.
- Source: Koyfin; tickers VUG, VTV, EFG, EFV.
- We suspect that the craze for AI related investments interrupted the adjustment in US growth even as it played out elsewhere. We’re believers in AI as a valuable technology, but it’s not at all clear that it should benefit growth stocks more than value stocks, or prevent the growth/value relationship from normalizing. We hope to explore that topic more in a coming article.