“It's quite reasonable to have an investment in U.S. stocks ... just don't go overboard on it." – Robert Schiller
Over the past six years the US stock market has dominated the rest of the globe, with the S&P 500 outpacing the MSCI All Country World ex US index by over 10%...annualized. In our highly correlated, highly globalized world this amount of outperformance from the largest developed component of the global index is nothing short of mind-blowing.
It’s widely known that diversification beyond stocks into other asset classes has detracted from returns, but the extent to which diversification within the stock market itself has hurt investors is perhaps even more noteworthy. If there was ever a time to have gone overboard on your allocation to US Stocks, the past six years was it! But regardless of whether or not you captured this trend for all it was worth (we certainly did not), is now the time to be doubling down on our domestic market? We think not.
As readers of this blog know, we don’t give much credence to market prognostications. There is just no reliable way of accurately predicting future performance, especially over short periods of time which are driven primarily by sentiment and emotion. However, from a longer term perspective, looking at market valuations is a good place to start in setting future expectations. And as one might expect, the relative strength of US Stocks over the past six years has resulted in pronounced overvaluation relative to other world markets.
The following table, using data from Morningstar and Star Capital, shows that as of the end of the year the United States was the most expensive global region (by far) as measured by six popular valuation metrics.
Perhaps the most widely respected metric in the list above is the Cyclically Adjusted P/E (“CAPE”) Ratio which measures price relative to a 10-year average of inflation-adjusted earnings. The CAPE Ratio has been shown to be a stable and reliable indicator of future long-term returns. Per data from Robert Shiller when the ratio is elevated (expensive) future returns are expected to be lower, and when the ratio is depressed (cheap) future returns are expected to be higher.
From the first table, we see that the CAPE ratio in the US was already above 25 at the end of last year. After factoring additional gains in the stock market for the first quarter, the CAPE Ratio now currently stands at nearly 30, putting US Stocks comfortably into the category highlighted in yellow above and suggesting a fairly dismal outlook over the next 5-10 years. But just because the US market appears overvalued, that doesn’t mean there aren’t more attractive opportunities around the globe. The map below, published by Star Capital, shows regional valuation levels by reflecting expensive valuations in red and cheap valuations in blue. One can quickly see that there is a wide valuation divergence between global regions.
Additionally, in their recent white paper Predicting Stock Market Returns Using The Shiller CAPE they combine an analysis of the CAPE Ratio and the Price to Book Ratio to arrive at long term return forecast for a variety of countries and regions. Due to its current state of overvaluation the United States has the second lowest forecasted return in the study at only 4.2% (see page 19 of the paper for more detail).
In a final example, a study published on GuruFocus.com derives its forecasts by looking at the CAPE Ratio as well as the total size of a stock market relative to its local economy (a measure described by Warren Buffett as “probably the best single measure of where valuations stand at any given moment.”) The results of this study also reflect a fairly dismal outlook for US stocks relative to their foreign counterparts.
The past six years obviously would have been a great time to have gone overboard on US stocks, but given the current state of valuations we wonder if investors should begin to actually start throwing them overboard instead. Our methodology, of course, is to identify and get in line with the trend. Over the past six years exposure within MarketVANE STOCKS* has averaged 69% US, 14% foreign and 16% cash. Given our trend following bent we will likely remain heavily tilted towards the US until after the relative leadership shift has been established, at which point we could, in theory, shift 100% into foreign markets.
No one has a crystal ball, and the market tends to make a fool out of those who prognosticate with any amount of certainty about the future direction of stock prices. There is obviously much more to market returns that starting valuations, but they remain an extremely important factor to consider. At the very least we believe expectations for US stocks should be tempered, and it seems reasonable to expect foreign stocks to assume relative leadership at some point in the coming years.
*Inclusive of some back test data prior to 7-2014.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.