The U.S. Equity Premium in a Global Context: Caution Amid Complacency

The U.S. equity market, long a magnet for global capital, now faces a critical inflection point. As of June 2025, the U.S. large-cap CAPE ratio stands at 33.9, placing it in the 96th percentile of historical valuations—a level rarely seen outside speculative bubbles [1]. In contrast, developed ex-U.S. equities trade at a CAPE of 18.7, while emerging markets (EM) and regions like Hong Kong and South Korea offer even more compelling valuations [2]. This stark disparity raises urgent questions about the sustainability of U.S. equity premiums and the growing risks of complacency in a market dominated by a handful of tech giants.

Valuation Gaps and Structural Imbalances

The U.S. market’s overvaluation is not merely a statistical anomaly but a structural issue. By the end of 2025, five stocks—predominantly in the technology sector—accounted for 45% of the Russell 1000 Growth® Index, with the tech sector alone representing 51% of the index [3]. This concentration has eroded diversification benefits, leaving portfolios vulnerable to sector-specific shocks. Meanwhile, global peers, particularly in Europe and EM, trade closer to long-term valuation averages, with real earnings growth outpacing U.S. counterparts [4].

The CAPE ratio divergence is particularly alarming. U.S. equities are now nearly twice as expensive as developed ex-U.S. markets, a gap that has historically narrowed during periods of global economic rebalancing [1]. For instance, non-U.S. equities outperformed U.S. markets by 10% year-to-date in 2025, driven by lower valuations and stronger earnings growth in Europe and EM [4]. This shift reflects a broader reallocation of capital toward markets where fundamentals and valuations are more aligned.

Underperformance and Factor Rotation

The U.S. equity premium, once a cornerstone of global investing, has shown signs of erosion. Kroll’s revised U.S. equity risk premium of 5.0%—down from 19.91% in 2024—highlights heightened macroeconomic and geopolitical risks [5]. This recalibration is not merely theoretical: U.S. value stocks, for example, recorded their fifth-worst quarter since 1990 in Q2 2025, while international value factors remain attractively priced [6].

Factor performance further underscores the U.S. market’s fragility. Growth and momentum factors, driven by AI-related earnings in mega-cap tech stocks, led Q2 2025 returns [7]. However, this outperformance masks underlying weaknesses. Quality and value factors lagged globally, with U.S. value stocks trading at levels reminiscent of the dot-com bubble [6]. Meanwhile, size factors saw a revival in Europe and EM, fueled by rate cuts and tariff optimism [7].

Diversification as a Strategic Imperative

The data paints a clear picture: investors must rebalance portfolios to mitigate U.S. overexposure. European banks and EM value stocks, trading closer to historical averages, offer compelling opportunities. For example, European industrials and EM exporters outperformed large-cap peers in Q2 2025, driven by rate cuts and a weaker dollar [7]. Similarly, EM markets like South Korea and Hong Kong present undervalued opportunities amid global economic uncertainty [2].

Diversification is not merely a defensive tactic but a proactive strategy. Morgan Stanley advises focusing on “higher-quality, less volatile assets” to counteract the U.S. market’s concentration risks [3]. This includes tilting toward international developed and EM equities, where valuation spreads are widening in favor of investors.

Conclusion: Navigating the New Normal

The U.S. equity premium, once a reliable source of returns, now faces headwinds from overvaluation, sectoral concentration, and global economic shifts. While U.S. equities still benefit from innovation and corporate governance, the risks of complacency are acute. Investors must adopt a more nuanced approach, leveraging international opportunities to balance exposure and capitalize on diverging valuations. As the global market evolves, the lesson is clear: caution, not complacency, will define the next chapter of equity investing.

Source:
[1] CAPE Ratios by Country (Global Shiller PE Ratios) [https://siblisresearch.com/data/cape-ratios-by-country/]
[2] Developed Ex-U.S. Equities: A Valuation Opportunity [https://www.advisorperspectives.com/commentaries/2025/05/30/developed-ex-u-s-equitie-valuation-opportunity-hiding]
[3] Remain Focused on Quality in Today's Concentrated Market [https://www.morganstanley.com/im/en-us/individual-investor/insights/articles/remain-focused-on-quality-in-todays-concentrated-market.html]
[4] Reassessing U.S. Equity Premiums Amid Sectoral Skew, Valuation Gaps, and Shifting Global Dynamics [https://www.ainvest.com/news/reassessing-equity-premiums-sectoral-skew-valuation-gaps-shifting-global-dynamics-2508/]
[5] Recommended U.S. Equity Risk Premium and Corresponding Risk-Free Rates [https://www.kroll.com/en/reports/cost-of-capital/recommended-us-equity-risk-premium-and-corresponding-risk-free-rates]
[6] Factor Views 2Q 2025 | J.P. Morgan Asset Management [https://am.jpmorgan.com/dk/en/asset-management/per/insights/portfolio-insights/asset-class-views/factor-views/]
[7] Looking Back at Equity Factors in Q2 2025 with WisdomTree [https://www.wisdomtree.com/investments/blog/2025/08/05/looking-back-at-equity-factors-in-q2-2025-with-wisdomtree]