How to add safety and potential returns to your portfolio … looking globally … finding strength in a weak dollar
Today, let’s make your portfolio safer.
At the same time, let’s put it in position to benefit from an asset class that could be about to soar.
Both offense and defense at once.
We’re going to do this by looking beyond U.S. borders to an asset class that the average American investor will never touch.
There’s a lot to cover, so let’s just jump in.
***How to avoid one of the most common mistakes investors make
Diversification.
It’s potentially the #1 way to protect your wealth.
The idea is simple — by spreading your money over an assortment of asset classes from different geographies, your overall wealth will hold up far better than by keeping your money in just one or two assets, and one of those assets collapses.
Most investors don’t do this.
Instead, the average U.S. investor focuses most of his money in one spot …
The U.S.
I’m referencing an investment phenomenon called “home country bias.”
As the name implies, home country bias is the tendency for investors to allocate a majority of their wealth to investments from their own country.
It doesn’t happen just here in the U.S. Investors all over the world do it in their own countries.
In a moment, I’ll show you a chart from Vanguard that illustrates this home country bias.
One of the chart’s 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 market size?
Large stock markets like those here in 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 below, all around the globe, investors put way more into domestic stocks than their own country’s weight deserves.
Here in the U.S., our market makes up a little more than 50% of the global weight, but we put nearly 80% of our investment dollars into the U.S. market.
That’s a lot of concentration!
Unfortunately, it generally means that if the U.S. market takes a nosedive, so too will the portfolio value of the average U.S. investor.
“So what, Jeff?” you ask, “U.S. stocks always outperform the rest of the world, so I should be investing more here at home anyway.”
Are you sure about that?
***U.S. stocks do not always outperform, despite appearances
My good friend, Meb Faber, is a quant investor.
He studies volumes of historical market data to create quantitative rules that tell him when and why to invest. His portfolios are global in nature and contain many different asset classes.
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. Yet, that’s not what we find.
Back in January of 2019, Meb wrote a piece that discussed the U.S. CAPE ratio.
CAPE stands for “cyclically adjust price-to-earnings” ratio. It’s a long-term measure of a stock market’s valuation that smooths earnings over a 10-year period.
Here’s what Meb wrote at that time:
As you can see below, as I write, the U.S. trades at a long-term CAPE ratio of around 29.
(Note: the chart below is from Meb’s dated piece. The current CAPE ratio is even higher today, coming in at 30.67.)
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.)
So, U.S. stocks do not always outperform the world.
However, they’ve been doing exactly that for years now — so why buck the trend today?
***Why you should add foreign stocks to your portfolio today … specifically emerging market stocks
If you’re generally a buy-and-hold investor with many years of being in the market ahead of you, then diversifying into foreign stocks would generally be considered a wise decision at any time.
Yet, today, there’s a new reason to look abroad …
The weakening U.S. Dollar.
As we’ve noted here in the Digest, the dollar is trading nearly 9% below its March peak, as you can see below.
Enter emerging market stocks.
To make sure we’re all on the same page, an “emerging market” references developing countries, the most notable are China, Brazil, and India.
This is different than a developed market (such as the U.S. or Britain) and frontier markets (think countries that are even less developed than emerging markets, such as Bahrain, Estonia, or Lebanon).
Now, here’s Fortune, explaining why a weakening dollar helps emerging markets:
A weak dollar would benefit foreign stock market companies and funds held by U.S. investors.
Those who own international stocks are subject to currency fluctuations, so if the dollar falls, that means your foreign stocks are worth more once they’re converted to our currency.
One of the biggest reasons international stocks have badly lagged U.S. stocks in recent years is because the dollar has been so strong.
We can look at historical market data to see the impact of a weak dollar on emerging markets.
Research-analyst Ben Carlson examined global markets from 1974 through 2019, studying average annual returns in years when the dollar was up versus years when it was down.
In “dollar up” years, emerging markets climbed a measly 2.7% on average.
However, in “dollar down” years, the average gain was a whopping 22.5%.
By the way, foreign developed stocks do well under a weaker dollar regime too. In dollar-down years, they averaged a gain of nearly 19%.
***One more reason to look beyond the U.S. today
As noted earlier in this Digest, U.S. stocks today have a high valuation as measured by the CAPE ratio.
For easy reference, here’s that chart again, showing the current value of 30.67.
Source: multpl.com
Now, if you’re buying stocks — or anything for that matter — the less you pay, the better, right? (Assuming constant value, of course.)
With that in mind, let’s look at some recent CAPE values for emerging market countries.
Below are select emerging market CAPEs, compiled by Meb as of July 2nd.
Czech Republic — 7.9
Russia — 6.2
Turkey — 7.1
China — 13.1
Brazil — 13.1
India — 18.7
Though these lower valuations are no guarantee that emerging market stocks will outperform, it certainly doesn’t hurt compared to the U.S. value of 30.
***Everything in moderation
To avoid confusion, I am not saying bail on U.S. stocks and put all your money into emerging market and foreign developed stocks.
Our InvestorPlace analysts remain incredibly bullish on select stocks here in the U.S.
But from a bigger picture perspective, let’s connect the dots …
The U.S. market is richly-valued …
Emerging market stocks offer far better values …
The dollar has been dropping fast in recent months with the Fed printing trillions of dollars — and that trend will likely mean a weaker dollar 12 months from today rather than a stronger dollar …
Emerging market stocks usually post strong returns when the dollar weakens …
And at the end of the day, it’s simply wise to spread your wealth over many different markets — especially with the U.S. CAPE ratio over 30.
For all these reasons, consider putting at least a small amount of your wealth into emerging markets today.
As one option for consideration, look at VWO, which is the Vanguard FTSE Emerging Markets ETF.
Below, you can see the weightings of its top 10 countries.
It comes at with a low 0.10% expense ratio and pays a 2.87% distribution yield.
***As we wrap up, let’s turn to a name that regular Digest readers will recognize, Ray Dalio
He’s one of the wealthiest, most successful hedge fund managers in the world. We’ve referenced his research many times here in the Digest.
Here’s Dalio on why spreading your money beyond the U.S. is a wise move:
In the past century, there have been many times when investors concentrated in one country saw their wealth wiped out by geopolitical upheavals, debt crises, monetary reforms, or the bursting of bubbles, while markets in other countries remained resilient.
… no one country consistently outperforms, as outperformance can lead to relative overvaluation and a subsequent reversal.
Rather than try to predict who the winner will be in any particular period, a geographically diversified portfolio creates a more consistent return stream that tends to do almost as well as whatever the best single country turns out to be at any point in time.
So geographic diversification has big upside and little downside for investors.
Take a few minutes today to look at your portfolio. To what extent is it showing home country bias?
If the answer is “a lot,” consider looking abroad today.
Have a good evening,
Jeff Remsburg
