Executive Summary
MSCI Europe has outperformed the S&P 500 by 7.79 percentage points over the trailing 12 months (USD terms)—the most sustained European leadership since the dot-com unwind. Trump’s tariff regime and European defense spending commitments triggered the rotation, driving a 10.7% P/E re-rating in European equities while US multiples compressed under policy uncertainty.
The current excess return reading places us in Quartile 1—the regime where Europe has most aggressively outperformed. Historical data from 26 years of Q1 episodes indicates:
1Y forward: S&P 500 median return of 9.91% vs MSCI Europe’s 1.62%
3Y forward: S&P 500 cumulative outperformance of +32.79 percentage points
5Y forward: S&P 500 cumulative outperformance of +52.94 percentage points
1. Current Situation: Quantifying the Excess Return Regime
Since the euro’s inception, the S&P 500 has compounded 680% versus MSCI Europe’s 371%—a 309 percentage point cumulative gap. The annualized alpha: 5.75% with a Sharpe ratio of 0.33 versus Europe’s 0.21. Risk profiles diverge: S&P volatility runs 19.0% versus Europe’s 20.4%, with maximum drawdowns of -55% and -63% respectively. The US spent 47% of time at all-time highs; Europe just 33%.
The Reversal: Europe’s Counter-Attack
The trailing 12-month excess return now sits at -7.79%—MSCI Europe is beating the S&P 500 by nearly 8 percentage points over the past year. The 3-month average reached -15.2% at its worst. The indicator has remained persistently negative since October 2025, marking the most sustained European outperformance episode since the 2000-2002 dot-com unwind.
What Triggered the Reversal?
The major averages were under pressure as worries over AI disruption and Trump’s tariffs pulled stocks lower. President Trump imposed IEEPA tariffs on US trading partners in 2025, including China, Canada, Mexico, and the EU—the Trump tariffs are the largest US tax increase in decades, creating policy uncertainty that weighed disproportionately on US equities.
Strong fourth-quarter corporate earnings, higher defense spending, and a lack of direct tariffs targeting Europe from the US appear to have contributed to the surge in stocks from Paris to Frankfurt. Stocks have also risen because of the growing understanding that Europe will have to spend more on defense—a fiscal catalyst absent in the US narrative.
The mechanism: Trump fiscal volatility created uncertainty around US growth assumptions while simultaneously catalyzing European fiscal expansion via defense commitments. European defense spending is expected to increase in the coming years, with the European Commission anticipating that defense investment could reach EUR 800 billion. This represents a rare European fiscal impulse benefiting cyclical sectors that dominate MSCI Europe.
2. Fundamental Drivers: Valuation Comparison
The S&P 500 trades at 27.6x forward earnings; MSCI Europe at 18.4x. That’s a 9.2 turn spread—Europe trades at a 33% discount to the US.
Twelve months ago, Europe’s P/E stood at 16.6x. The current 18.4x reflects a 10.7% re-rating. Europe outperformed the S&P by ~8 percentage points over the trailing year, but P/E expansion accounted for most of this—implying EPS contributed negatively (approximately -3% drag). The outperformance was valuation-driven, not fundamentals-driven.
This distinction matters for forward expectations. Multiple-driven rallies face diminishing returns as absolute valuations rise. Europe at 18.4x is no longer cheap in absolute terms—it’s merely cheaper than an expensive US market. The 33% discount provides a valuation cushion, but the next leg of European outperformance requires earnings delivery rather than continued re-rating.
3. Excess Return Regime Analysis: Forward Return Expectations
The trailing 12-month excess return of -7.79% places us in Quartile 1 (Q1)—the regime where Europe has most aggressively outperformed the US. Q1 captures periods when rolling 1Y excess return falls below -3.37%. We’ve occupied this regime consistently since early October 2025.
S&P 500 Forward Returns by Quartile
From Q1, the S&P 500 delivers median 1Y forward returns of 9.91%—the weakest 1Y outcome across all quartiles. The 5Y median of 56.32% trails Q3 and Q4 significantly (94% and 92% respectively).
MSCI Europe Forward Returns by Quartile
Europe’s pattern is striking. From Q1, MSCI Europe delivers median 1Y forward returns of just 1.62%—the weakest absolute return profile. The 3Y and 5Y medians are essentially flat (-0.91% and 3.38%). When Europe has already outperformed significantly, forward absolute returns compress sharply.
Implied Excess Return Dynamics
From Q1, the median 1Y forward return differential is +8.29 percentage points in favor of the S&P 500 (9.91% vs 1.62%). The pattern extends across all horizons:
The historical pattern is unambiguous: Q1 regimes—where Europe has recently outperformed—are followed by US reassertion across all forward horizons. The reversal is most pronounced at the 3Y and 5Y marks, where S&P cumulative outperformance exceeds 30-50 percentage points.
4. Conclusion: What the Regime Data Implies
The data presents a clear historical pattern. When the trailing 12-month excess return falls into Q1 territory (Europe outperforming by more than 3.37%), forward returns strongly favor the S&P 500 across all horizons. The current reading of -7.79% sits deep within Q1, indicating an extended period of European outperformance that historically precedes US mean reversion.
Three observations from the regime analysis:
Near-term momentum may persist. The current Q1 regime began in October 2025. Historical Q1 episodes (dot-com unwind, financial crisis) lasted 12-18 months. We’re approximately 5 months into this episode—suggesting the regime may have room to run before exhaustion.
Absolute return expectations diverge sharply. The median 1Y forward return for MSCI Europe from Q1 is just 1.62%, versus 9.91% for the S&P 500. This isn’t merely relative underperformance—European absolute returns compress significantly following extended outperformance episodes.
Long-horizon reversion is historically consistent. Q1 entry points produced 32.79 percentage points of S&P outperformance over 3 years and 52.94 percentage points over 5 years. This pattern reflects the structural alpha the US has generated since 1999—periods of European outperformance have been counter-trend moves, not regime shifts.
The valuation gap (33% P/E discount) and European fiscal catalysts (defense spending commitments) provide fundamental support for the current outperformance narrative. But the regime data indicates that such episodes have not historically persisted—they’ve marked late-stage rotations followed by US reassertion. The current outperformance triggered by Trump fiscal volatility and European defense spending represents a cyclical rotation within a secular trend of US dominance.
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Past performance does not guarantee future results, which may vary. The economic and market forecasts presented herein are for informational purposes as of the date of this presentation. There can be no assurance that the forecasts will be achieved. Copyright 2025 Alpha Rho Technologies LLC. All rights reserved.