I am a huge Patriot and a big fan of U.S. stocks over the long run. U.S. stocks are the largest holding for the vast majority my client partners. However, U.S. stocks have underperformed cash in 3 of the last 9 decades; 1930’s, 1970’s and 2000’s. A lost decade is unacceptable for my client partners so having some balance to economic environments, regions and valuation disparities is critical while also pursuing opportunistic investments and extreme tax efficiency.
This memo is not meant to bash U.S. stocks or call the current U.S. stock market a bubble (although it might be). It is a call for diversification and to extoll the merits of that approach while highlighting the psychological biases I have witnessed over my investing career.
“Good judgment comes from experience, and a lot of that comes from bad judgment.”
― Will Rogers
At the beginning of 1999, the United States stock market looked utterly unstoppable. Naturally, this is when I became obsessed with stocks. The performance had its justifications as the U.S. was the epicenter of the latest technological innovation, the internet, which also fueled a media and telecommunications boom and resultant infrastructure capital growth cycle. The positive economic cycle led to the consensus groupthink that the U.S. was the only place in the world worth investing.
Given the U.S. dominance, why invest anywhere else, especially considering the ugly financial issues in the world. For instance, the boom-and-bust cycle of the “Asian Tigers” in 1997 led to massive currency devaluations across the region and lost capital for investors. The Asian crisis was followed by the Russian debt crisis in 1998, Brazil in 1999 and Argentina’s debt default in 2001. Shall I go to clients and tell them I am buying Thailand or Korea or Emerging Markets overall? Go ahead…if you want to get fired. People have families to feed…better to fail with the crowd.
From 1/1/99 to 4/1/11:
- $100,000 invested in the Emerging Markets stock index turned into $530,000
- $100,000 invested in the S&P 500 index turned into $136,000
For context, the S&P 500 peaked in early 2000 at 25x earnings with the U.S. 10-year interest rate at 6.2%. The price to 10-year earnings ratio (or CAPE ratio) peaked at 35x, an all-time high. The difference between U.S. and Emerging Market valuations was also at an all-time high. Empirical research has proven that valuation is a very poor predictor of stock market returns in the short term, but a very good predictor over the long term. Being right over the long term typically requires looking foolish over the short term.
In 2011-2012, another bleak situation existed. This time there was a sovereign debt credit rating downgrade, malfunctioning stock trading or “flash crashes,” government gridlock, >90% debt to GDP, higher taxes, stifling new regulations and a busted technology IPO. Emerging Markets again? No, this time it was the United States and the busted tech IPO was Facebook. From the 2000 stock market peak to 2011, the S&P 500 was flat and Microsoft traded at 10x earnings.
Who reading this memo was aggressively buying U.S. stocks or predicting one of the greatest bull markets in U.S. history? It seems so obvious now.
However, do you recall the BRICs (Brazil, Russia, India, China) at this same time in 2011? Emerging markets were set to take over economic and financial market supremacy from the U.S. while “decoupling” from the rest of the world. Emerging Markets were in fact booming and in the rear-view mirror, the cumulative stock market performance was impressive. Greed follows excellent stock market performance and cognitive misjudgment errors result from greed. Investor losses or massive underperformance ensues.
From 4/1/11 to 3/31/24:
- $100,000 invested in the S&P 500 index turned into $490,000
- $100,000 invested in the Emerging Markets stock index turned into $119,000
For context, today the S&P 500 is trading at 21x earnings with the U.S. 10-year interest rate at 4.4% (not nearly as stretched as 2000). The price to 10-year earnings ratio (or CAPE ratio) is again at 35x, matching the 2000 all-time high. The difference between U.S. and Emerging Market valuations is approaching a new all-time high. U.S. stocks have performed excellent in 2024 (up 10%) as they correctly anticipated the current strong economic growth.
All told, the S&P 500 and the Emerging Markets stock index have had very similar performances over this entire 24+ year period. Surprised?
From 1/1/99 to 3/31/24:
- $100,000 invested in the S&P 500 index turned into $667,000
- $100,000 invested in the Emerging Markets stock index turned into $630,000
Would it surprise you further that the barbarous relic, Gold, turned $100,000 into $770,000 over the same period…easily outperforming the S&P 500? I am not a Gold hoarding, doomsday prepper, but could this be The Money Illusion at work?
Gold has gotten a decent amount of press lately since it’s up 14% year to date and outperforming the S&P 500, but that is for another memo. Please refer to my 2021 memo on the topic Gold: Portfolio Insurance & Purchasing Power Protection.
This memo is not an attempt to predict the future strong performance of Emerging Market stocks nor to denounce the U.S. However, after performing this analysis and thought experiment, I wonder if the approximate 10-15% of client partners’ equity allocation to Emerging Markets is too low. The discipline of diversification requires saying “no” to extremes. Most people own zero Emerging Markets. How could their advisors justify owning any given the return disparity of the last 13 years? Remember, people have families to feed …better to fail with the crowd.
From 1/1/99 to 4/1/11, a mere 15% weighting in the Emerging Markets stock index would have led to 50% higher stock returns vs. a 100% U.S. stock allocation.
I am loathe to write about short term dynamics, but I get it, people care. Recall my comments from last quarter:
“The Fed’s dot plot expects the Fed to cut rates 3 times over the coming year. I disagree, yet the path is uncertain. If the economy is strong, no cuts are likely and interest rates remain “higher for longer” to suppress further inflationary bursts. In this scenario, a re-acceleration of inflation is likely at some point. However, if the economy falters and deflationary forces kick in, we could see the Fed funds rate go below 3% and new fiscal stimulus, sowing the seeds for the next inflationary up-cycle.”
Thus far, the strong growth + inflation reacceleration scenario is playing out with Fed rate cuts being pushed out on the calendar. As a result, portfolios have benefited from not only gold investments but commodities as well. My view remains that disinflationary forces are cyclical in what will be higher structural inflation in the current decade. The continued intensifying global conflict further supports this view. For a review of our long-term view of inflation, please refer to our 2021 writings on our website: Inflation: Secular Analysis by Essential Partners
I appreciate your continued trust and support.
Nick
Investment advisory services offered through Essential Partners, LLC, an SEC registered investment adviser.
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