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My pal Adam Collins from Movement Capital tweeted out a CFA article the other day that is so intriguing, I have to write about it.
The article is titled “International Equities: Diversification and It Discontents” by Ford Donohue, CFA. It’s one of those articles that is so good my only response is, “I wish I had written that”.
Let’s dig into the article by starting with Ford’s opening paragraph:
Many US investors allocate to international equities in the belief that it diversifies portfolio risk without compromising long-term returns.
Over the past 50 years, adding non-US stocks to a stock portfolio has lowered portfolio volatility while also improving returns. Nothing new in this revelation. However, it’s this next part that Ford parts company with traditional portfolio theory.
While this may have been true in decades past, the evolution of the global economy has altered the relationship between US and international stocks. Today, equity investments in many of the developed economies that dominate the MSCI EAFE and ACWI ex USA indices yield little in the way of diversification benefits.
To prove his point, Ford includes a chart over the past few decades showing how much US Equities would be needed in a portfolio of American and EAFE (Europe, Australasia, and Far East) stocks to maximize return each year:
I can already hear the complaints – “yeah, but the whole point of adding EAFE is to lower risk while maintaining return, so that’s not a good chart.” Yup. That’s why Ford made the same chart except for risk-adjusted the returns:
Let’s take a moment to think about what this chart means.
Ever since the Great Financial Crisis, any addition of EAFE to a portfolio of US stocks has resulted in both less total return, but more importantly, less risk-adjusted return.
You might say, “so what? Isn’t that obvious?”
Sure, everyone knows that American stocks have been the only place to be over the past decade.
What’s happened to those who battled against this trend?
Portfolio managers that liked Europe because they were “cheap”? Replaced by a smart-beta S&P 500 index fund. That guru who said Japanese small-caps were the place to be? Hobby farm in the mid-west still writing an occasional Seeking Alpha post (after all, Japanese small-caps are now even cheaper). That emerging market manager who sounded so smart on CNBC? Trying to keep a low profile to avoid reminding his boss that they still manage money in a country other than the United States.
The truth of the matter is that everyone knows that American stocks are the only place to have invested over the past decade. Heck, my grandmother phoned me up the other day to complain about my recommendation to own some emerging market ETF in her portfolio. She didn’t like my response so she has taken to trolling me on twitter.
What’s amazing about these charts is that the math clearly demonstrates what we all knew intuitively. The efficient frontier seems to have shifted to the point where the only answer to portfolio allocation is to be “all in” when it comes to American equities.
Has the world truly changed to the point where it makes no sense to be long anything except American equities?
Or is this simply a case of the market chasing the latest best performing strategy? When I see a trend going one way for a decade, I can’t help but worry that the market has completely discounted the phenomenon.
I am aware of all the theories about why this trend has only started – why the US will continue dominating the world and there is no sense owning any other country’s equity market (or even anyone else’s currency). Don’t send me your different theories – you will only encourage my belief that it’s already priced into the market.
When portfolio allocators conclude there is no benefit to diversifying out of U.S. stocks in even the tiniest little bit, it’s time to pull out the pink tickets. The market loves to do the exact opposite of “what everyone knows for sure”. The only question is the timing.
I think 2020 could be the year when the trend of US equities outperforming the rest of the world finally ends. The market is not positioned for this possibility. If it happens, then the move will be more violent than most realize. Once it starts, don’t fade it. Jump aboard. It will last longer than almost anyone can imagine. When my grandmother phones asking if she should sell her SPY and buy EEM, I will let you know it’s safe to buy the US again.
I read a piece recently that claimed that US and emerging market stocks with similar sector and quantitative profile’s perform similarly over the long term. It more about the stock than its geographic location.
What would the Dow be worth if interest rates were at the 200 year average? 15K? 10K? Less?
And if interest rates remain zero? 50K? 100K? In my mind, gravity always wins.
I stumbled onto Jeff Gundlach’s interview at CNBC the other day. Interesting to hear a view that goes out years rather than days. https://www.cnbc.com/video/2019/12/11/watch-cnbcs-full-interview-with-jeffrey-gundlach.html
Have worked your last paragraph independently (bigly wrong) for at least a couple of years…. The reason is as always the zigs and zags that tell me that the narrative is being manipulated out of desperation by forces that are inadvertently painted into a corner.. High debt levels ,low interest rates beget what we have gotten …. As you always say ,Kevin, “I am not here to tell you what should but rather what is gonna’ be” ….Trouble is the timing….as well as selection of hedges…..This is a good post you have written today …thanks…