Diversification, Emerging Market Outperformance, and the Prospect of a Flat US Stock Market

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This just in: US equities have been on a rampage for the last decade.

Here's a fun fact: If you invested $100,000 in the SPDR S&P 500 ETF at the peak of the market in 2007 your investment would have plummeted to a low of $43,500 in March of 2009.  However, had you stayed the course and not sold at the bottom, your original investment would have more than doubled on a total return basis at present market levels.

That is amazing, and a strong argument for buy-and-hold investing and staying cool under pressure (i.e. not panicking and selling at the bottom of a bear market).

When the good times get rolling, as has been the case for US stocks, people start to expect more of the same.  The market starts to feel safe for investors for the simple reason that it has been going up.  However, prominent research organizations, like the well-respected Research Affiliates are arguing that U.S. markets will likely be flat over the next 10 years. Flat?

Yes.  Research Affiliates believes both US stocks and bonds, and as a result, the common 60/40 portfolio allocation (60% US stocks and 40% US bonds) will offer a big fat zero over the next decade.

Check out the following chart from Research Affiliates (via PIMCO):

Research Affiliates’ research, like others in the space, is based upon stock valuations, or price in relation to underlying fundamentals like revenue, earnings, or book value. Though there are no guarantees, and research like this is not a timing device, cyclically adjusted valuation models such as the one Research Affiliates employs have beenpredictive of future stock market returns over a long period of time. In other words, it is nearly impossible to predict next month's or even next year’s returns, but we can say with a degree of confidence what the next 7-10 years may resemble. 

For the first two years of the current bull market, global stocks behaved in lockstep. Solid returns in one market usually signified solid returns in another market. But something weird started happening in 2011, U.S. markets continued to go up even as emerging market and international stocks fell into a long and volatile malaise. The U.S. equity market was displaying what is called 'relative strength.'

Now, there are a whole host of reasons why this might have been the case and why it intensified in 2014. The dollar was rising. Our economy seemed stronger than global alternatives. Our corporations had more easily shed costs after the Financial Crisis. International stocks were overvalued. However, the rationale is not necessarily important. What is important is that there were more buyers for U.S. stocks (e.g. there was more investor demand) than there was for international equities (more on this below).

A Change in the Tides

Here's why this is interesting. Despite a short-term drop after President Trump’s election due to concerns about protectionist trade policies, international and emerging market stocks have dramatically outperformed their US counterparts since 2016.

Chart 2: Emerging Markets Have Outperformed Since 2016

More, though there are no guarantees, we expect this trend to continue for a period of years. Why? Well, first because of the relative strength mentioned above.  The chart below shows that periods of relative strength between international and domestic stocks tend to run for years.  For example, from 2001 to mid-2008, emerging markets were the place to be (as were international stocks in general).  While US large-caps did nothing for a decade, emerging markets dramatically outperformed.  However, since the Financial Crisis, this trend reversed and US stocks dramatically outperformed their international counterparts.  Importantly, we think the trend just changed again in favor of international stocks as you can see in Chart 3.  

Chart 3: Relative Performance between Emerging Markets and US Stocks

Valuation research leads to the same conclusion.  Above, in Chart 1, emerging markets equities are forecasted to return nearly 6% annually over the next decade after inflation.  This contrasts with the nearly flat forecast for US stocks.   

Once again, there are multiple reasons why this may be the case.  Global growth is picking up.  Inflation seems to be becoming a real concern.  The US dollar has been falling boosting foreign currencies.  International stocks are under-owned versus US equities. However, the most important factor is that there seem to be more buyers for international stocks relative to US stocks.  This shows up in the relative performance above. 

Home Bias and Diversification

Does this mean that emerging market and international equities will outperform every year? No.  Does it mean that they will only go up? No, they may encounter time periods of negative returns.  Does it mean that that US stocks are set for a bear market and we should all run for our bunkers?  No, it doesn’t mean that either. 

We simply believe that international and emerging markets equities are set to outperform for the next 5-10 years and that if you are disproportionately invested in US stocks, as many are, now could be an opportune moment to diversify.  

Most investors display what is called a 'home bias’ that is, they largely own domestic companies. The common 60/40 portfolio discussed above, is a manifestation of this bias. However, smart investors know that there is much beyond our borders. A whole world full of well-run and, in many cases, reasonably priced and growing companies. 

In fact, owning more US companies simply because you live in the US simply doesn’t make sense anymore.  Trailhead Planners has offices in Portland, Oregon and Minneapolis, Minnesota.  Should we urge our clients to buy more Intel, Nike, Medtronic, and Target stock simply because they are homegrown?  No.  If you're not already, now is the time to look beyond our borders and invest globally.

Wondering if your investment portfolio is diversified or how best to capitalize on the potential outperformance of international equities?  Setup a free consult with one of our financial planners here:

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