If history is any guide, U.S. returns will underperform over the next decade. But here’s one country that’s crushing it that can help you diversify your wealth today

How do you lose $35 billion … in two years?

Sounds impossible. But it’s easier than you think.

Ask Eike Batista.

He made one common investing mistake that cost him all that money.

In 2012, the self-made Brazilian billionaire had an estimated worth of more than $35 billion. He had created an empire that stretched from mining, to oil, to public works.

Barely two years later, all $35 billion was gone … and he owed an additional $1.2 billion to creditors.

How does one lose $35 billion in less than two years? You could identify several poor decisions, but perhaps the biggest of all was concentration. Batista’s wealth was largely tied to the global commodities boom. While that investment concentration enabled Batista to generate massive wealth when times were good, it proved his downfall when times were bad.

“Concentration” doesn’t just happen with asset classes like commodities. You can be dangerously concentrated in a specific stock, or a sector, or even a single country’s stock market.

As to country-concentration, this 10-year bull run we’re enjoying can distort our perception, but the U.S. stock market can go nowhere for long stretches.

For instance, leading up to this wonderful bull, the S&P delivered its worst five-year return of -6.6% a year over the five years ending in February 2009. While returns like that may not destroy $35 billion, they can destroy retirement dreams, savings for college tuition or a down payment on a home, or general wealth-building.

This is what we want to avoid — being too concentrated in just one country’s market when that market rolls over … or just goes nowhere.

In today’s Digest, we’ll dig into this more — specifically, our tendency to invest only in the U.S. stock market … why the next decade might be a bad time for the broad U.S. market … and then we’ll point toward one country that’s been crushing the U.S. market over the last 12 months that could help you diversify and grow your wealth.

Let’s dive in.

***The investment mistake everyone around the globe makes

When it comes to country concentration, the term is “home country bias.”

As the name suggests, home country bias is the tendency for investors to allocate most of their money to investments in their own country.

It’s not a uniquely American phenomenon. It happens to investors all over the world.

Below is a chart from Vanguard that shows this home country bias at work. One of its inputs is a given country’s global index weight. In other words, if we looked at the entire world as one big investment market, how much “weight” should a specific country have within that global portfolio, based on its size?

Large stock markets like that of the U.S. would have a bigger “weight” of the global market portfolio than a smaller stock market, like the one in Australia.

The second variable in the chart below shows the percentage of domestic stocks that investors in each country hold in their portfolios. As you can see, all around the globe, investors put way more into domestic stocks than their own country’s weight deserves.

 

 

Notice how here in the U.S., we put nearly 80% of our investment dollars into the U.S. market! Of course, on a percentage basis, the Australians are way worse.

***”So what?” you ask, “U.S. stocks always outperform the rest of the world, so I should be investing more here at home anyway”

You might want to think again about that.

My good friend, Meb Faber, is a “quant” investor. In other words, he studies historical market data to create quantitative rules. These rules help guide him as to when and where to invest, so that he’s making informed market decisions, not emotional-based market decisions.

If the U.S. market always outperforms the rest of the world, Meb is the guy who could verify that given his expertise at historical market analysis. Unfortunately, that’s not what we find.

From a piece Meb wrote back in January:

As you can see below, as I write, the U.S. trades at a long-term CAPE ratio of around 29.

(Note: “CAPE” stands for “cyclically adjust price-to-earnings” ratio. It’s a long-term measure of a market’s valuation. And it’s actually higher now — 30.06 as I write.)

 

This level is fairly high from a historical perspective. For further context, the average CAPE from countries around the globe is roughly 16. That makes the U.S. level nearly double that of the average global country …

… if the U.S. market is so fantastic that a higher valuation is always warranted, then historically, it should always have a higher valuation.

But that’s not what history tells us.

Below is a chart showing the U.S.’s CAPE versus the world ex U.S. (i.e. foreign stocks). Going back to 1980, both have an average CAPE ratio of about 22. Let me repeat: the historical valuation premium has been ZERO.

Beyond that, the amount of time each spends being more expensive than the other is basically a coin flip. That stat surprises a lot of people who assume that the U.S., being currently expensive, ALWAYS trades at a premium and for some reason “deserves to”. (After all, the U.S. is special.)

 

***It’s important to note the correlation between valuation and future returns

So, we invest too much in our home countries … And historical analysis shows that no one country always outperforms …

The wise investor would ask “how can we know when a country is going to do well versus poorly?” It turns out there’s a blunt tool we can use. It’s not a perfect timing tool, but it’s still very helpful. Think of it as a hammer, rather than a chisel.

We referenced it early — it’s called the CAPE ratio.

In short, the takeaway of the CAPE ratio is this:

Markets tend to revert to the mean over time. So, a country that has a high CAPE value today is more likely than not to see its value fall in the coming years. That would mean below-average stock returns.

On the flip side, a country that has a low CAPE value today is more likely than not to see its value rise in coming years. And that would be based on above-average returns.

The more extreme the starting CAPE value (either high or low), the more pronounced those 10-year returns often are.

Below is a chart from Meb. Starting in 1900, the chart shows initial CAPE values and what the 10-year returns ended up being based on those starting CAPE values.

Dark green represents the cheapest CAPE starting years. Red represents the most expensive.

As you’ll see visually, most of the “green” starting years (low CAPE ratios) end up on the right side of the chart — meaning big 10-year returns.

On the flip side, “red” starting years (high CAPE ratios) usually end up on the left side of the chart — meaning low and negative 10-year returns.

It doesn’t always work this way — but it works enough to be incredibly helpful to a long-term investor. Remember, we’re talking a hammer, not a chisel.

 

Now, remember, as I write, the U.S. Shiller CAPE Ratio is at 30 — which puts it deep into those “red” starting years.

Conclusion?

Odds suggest the broad U.S. stock market will significantly underperform over the next decade.

Do you want to be concentrated in this market?

***So, if the U.S. is looking bad, where might you go to diversify some of your wealth?

I’m going to suggest a country that might be the last place you’d expect to be investing …

Brazil.

Now, I’m not saying sell everything and put it all into Brazil. That would be foolhardy and would be making the same concentration mistake, just in a new country.

But automatically thumbing your nose at Brazil would be equally foolhardy. Why? Well, take a look at the chart below. It shows the Brazilian market compared to the U.S. market over the last 12 months.

While the U.S. market is up 6% year-over-year, Brazil has soared 36%.

 

Despite this massive growth, can you guess Brazil’s CAPE ratio level?

About 16.

In other words, basically 

half the valuation of the U.S. stock market!

***For more on why Brazil might be a great investment, let’s turn to Eric Fry, editor of Fry’s Investment Report

Eric is a world-class, global macro investor. He’s also a former hedge fund manager, and author with a legendary status in the financial industry. Given this, we’re thrilled he’s joined the InvestorPlace team as editor of Fry’s Investment Report.

Here’s what Eric recently wrote to subscribers:

Brazil is a “Buy” today.

Why? Because it is one of the most obvious beneficiaries of the intensifying trade war between the United States and China.

As we just talked about, ever since trade hostilities broke out early last year, Chinese importers have shifted a significant portion of their supply chains from U.S. producers to non-U.S. producers.

Brazil is one of those non-U.S. producers.

International trade, like water, flows along the path of least resistance. So when governments toss tariffs into the middle of trade flows, like boulders into a stream, the trade will simply make a new path.

That’s why the Brazilian economy is likely to emerge as one of the biggest winners of the Chinese-U.S. trade war.

But on this note, I asked Eric, “If the U.S./China trade spat is resolved, does that hurt Brazil?”

Eric told me he doubts it. He believes the tariffs have already pushed China away from the U.S. resulting in the establishment of new trade patterns. Even if the U.S. and China resolve their issues, at this point, China’s connection with Brazil will be difficult to undue quickly.

Eric then goes into additional details on various tailwinds behind the Brazilian economy and stock market.

He references Brazil’s low stock market valuation (which we touched on earlier when mentioning CAPE) noting that, despite big 1-year gains, the Brazilian index is still 40% below the all-time high it reached in 2011.

He then points toward a strengthening economy.

From Eric:

Although the Brazilian economy is not booming, it is clearly on the mend. The nation’s severe economic recession of 2015-’16 is over, and the economy has produced positive growth for the last two years. Employment growth is trending higher as well.

These positive economic signs coincide with a growing trade surplus and a revival of foreign direct investment (FDI) in the country.

 

Eric then highlights Brazil’s strengthening currency and a potential tailwind involving comprehensive pension reform.

If you’re interested in Brazil, Eric tells us that one of the easiest ways to invest is through the iShares MSCI Brazil Capped ETF (EWZ). This ETF holds a portfolio of major Brazilian stocks like Itaú Unibanco Holding SA (ITUB), Vale SA (VALE), and Petróleo Brasileiro SA (PBR), more commonly known as Petrobras. EWZ also offers a healthy dividend yield of 2.7%.

For more from Eric on Brazil and the other macro opportunities he’s seeing, click here.

***Let’s pull back now and remember the big picture

Over the past few weeks, we’ve been featuring Eric in the Digest. This is because our CEO, Brian Hunt, asked Eric to create Bear Market 2020: The Survival Blueprint in light of the reality that this amazing bull run here in the U.S. simply won’t last forever.

Part “diary” and part “owner’s manual,” Eric’s book walks you, step-by-step, through the simple strategies that will help you and your family navigate America’s next bear market.

Part of this strategy involves diversifying your assets. And as we’ve discussed today, having all of your wealth concentrated here in the U.S. is a bad idea when looking at our current CAPE levels, and projecting what that is likely to mean for U.S. returns over the next decade.

But investing in other countries, like Brazil, is just one of the safeguard actions steps. There’s much more you can do. For the other strategies Eric recommends, click here.

In any case, if you’re 100% invested in the U.S. market, history and Eike Batista suggest you should re-think that.

Have a good evening,

Jeff Remsburg