2015 First Quarter Client Commentary
“The time to get interested is when no one else is. You can’t buy what is popular and do well.”
“Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.”
“The investor of today does not profit from yesterday’s growth.”
– Warren Buffett
The words above have been spoken often by Warren Buffet, one of the most-respected and accomplished investors of our time. We find his wisdom helpful with the significant return differences over the past several years between U.S. stocks and international stocks, as well as, when we evaluate the effect these return differences have had on portfolios.
As you review the chart below you’ll see that U.S. stocks have now outperformed developed international stocks for the fourth time in the past five years and they have outperformed emerging market stocks for the third time in the past four years. Even though owning foreign stocks has been an unsatisfying experience over the past five years, we continue to believe there is a very strong case for owning foreign securities in your portfolio. The purpose of this letter is to help you better understand the “why” behind global diversification.
We also believe Mr. Buffett’s comments are insightful as it seems many investors are attracted to the strong trailing returns of the U.S. market. In the investing world this is known as following the herd mentality (i.e. chasing past performance or investing in what “was” hot). Following the herd is a common mistake and the reason many fail. Investors dive into the market with enthusiasm when everything seems to be all sunshine and they sell after a decline or sit on the sidelines frozen in fear when opportunity is staring them in the face.
As anecdotal evidence of the herd mentality in action, we’ve recently been talking to clients who are very interested in investing only in Large-cap U.S. stocks because they have performed the best over the past couple years and this trend must certainly continue…….they believe. At the same time, they want to entirely abandon investing internationally…….because the significant underperformance is surely going to continue, they believe. If you truly believed in the wisdom of Mr. Buffett wouldn’t you question that approach? Might you instead seek value in out-of-favor areas? For many investors this is hard to do because there is an overwhelming tendency to follow the perceived safety of the herd. It’s important to remember that investments favored by the herd can easily become overvalued because eventually herd-driven optimism pushes prices above what can be supported by fundamentals.
We’re not saying that U.S. stocks are significantly overvalued, or that the trend will immediately shift to favor international markets. We believe U.S. stocks are roughly trading at fair value with the S&P 500 index priced at 16.2x earnings. This Price-to-Earnings ratio is close to its long-term average of 15.6x earnings. We also believe the U.S. economy will continue to strengthen this year as it’s bolstered by falling unemployment, lower energy prices and higher consumer confidence.
We also believe that we’ll see an improving global economy as we move through 2015. Central banks of Europe, Japan and China are each implementing very aggressive monetary actions to spur economic growth, the European sovereign debt crisis has faded, lower currency values for the Euro and the Yen favors growth for exporters and lower oil prices benefit Europe, Japan and other Asian economies.
The Case for Global Equity Exposure (despite “everyone” knowing the United States is the place to be)
The first key point is to remember that equity markets and asset classes in general go through cycles and it is unwise to extrapolate recent performance trends far into the future. Furthermore, investors often suffer from extreme overconfidence that they can predict these shifts and correctly time their buys and sells accordingly (data show actual investor returns lag indexes by hundreds of basis points due to timing errors – source Dalbar). As an example, we were hearing this same question back in the late 1990s/early 2000s after U.S. stocks had a similar streak of out performance. As shown in the chart to right, in the market cycle that followed from 2002–2007, international stocks trumped U.S. stocks by a wide margin, and emerging markets did even better, outperforming the S&P 500 by more than 20 percentage points annualized. (Of course, toward the end of the latter period people were asking why they didn’t have more exposure to emerging markets……only to see emerging markets meaningfully trail the U.S. market since then.) Because markets move in cycles, there will always be periods when global diversification doesn’t appear to “work.” In our view as long-term investors, the case for global investing remains compelling and extends beyond the simple matter of capturing returns as market leadership rotates.
The most important reason to hold a globally diversified portfolio is to access a much broader investment opportunity set. In
1970, U.S. GDP accounted for 47% of the world’s total GDP. Today it is closer to 20%, while emerging markets now comprise
roughly half the world’s total output. Likewise, in terms of stock market capitalization, in 1970 the U.S. market comprised 66% of the world’s total stock market value. By 2014 it had declined to roughly 51%, with emerging markets comprising 11%, and the remainder in developed international markets as can be seen in the pie chart to the right. In other words, businesses around the globe are launching, innovating, producing, and growing, and their stocks have the potential to do so as well. If an investor chooses to only invest in U.S. stocks, they are excluding themselves from over half of the world’s total investment opportunity set. Moreover, they are limiting their opportunity to invest in some of the world’s most attractive companies domiciled outside the United States.
Another important reason for owning a global stock portfolio is the benefit of diversification. A diversified global equity allocation should produce better longer-term risk-adjusted returns than any single country held in isolation. This has been the
case historically as shown in the chart to the left, which extends back to 1970 when data for the developed international market index begins, and incorporates emerging markets starting in 1988 when their index returns became available. Looking at rolling 10-year periods, the global portfolio (comprised of 60% S&P 500 and 40% non-U.S. stocks) generated an average return of 12.5%, beating the S&P 500’s average return of 11.3%. (The results were similar using rolling five-year periods.) Moreover, the global portfolio beat the S&P 500 in 71% of the rolling 10-year periods (there are 420 such periods going back to 1970). Countries around the world are in different stages of their economic and market cycles, and at any given time one particular market can and will outperform others. Consistently predicting which market will outperform, and more importantly getting the short-term timing right, is impossible. If you concentrate your exposure in only one market—even if it’s the U.S. market—you run the risk of that market undergoing an extended period of underperformance that could have a lasting negative impact on your portfolio. And human nature is such that most people also won’t be able to stand being heavily invested in an underperforming market for too long. This discomfort may lead them to sell in disgust at low prices and chase the recent country market winners, probably just as those markets approach their highs for the cycle. In other words, after studying the long-term returns of a globally diversified portfolio, an investor must ask themselves if they will still feel it is imperative to adjust their portfolio to be concentrated in U.S. Securities (the market with the best performance in recent years). Then if the portfolio is adjusted to concentrate in the U.S., the investor must be ready to accept those years in the future when the U.S. market underperforms the rest of the world.
That is why diversification—consistently owning a variety of asset classes, and strategies which should perform differently depending on the environment—enables us to create portfolios that should perform at least reasonably well across a wide range of possible scenarios and outcomes. But it takes discipline to be a long-term diversified investor, because you know you will own some asset classes that are laggards in any given year or even over multiple years, and with 20/20 hindsight it is easy to start questioning why you owned those particular assets in the first place.
In the end it is critical that we to stick to our investment discipline, execute on our thorough research, remain intellectually honest with respect to what we can and can’t know and the effort we make, and remember that we manage money for real people with emotions, rather than hypothetical portfolios. At the end of the day, we view our responsibility in terms of your needs more than benchmark comparisons. We appreciate your continued confidence and trust, and all of us at Payne Wealth Partners share our best wishes for a happy, healthy, prosperous, and peaceful New Year.
Sources: Envestnet/Tamarac, Littman Gregory Research and JP Morgan
As always, we welcome your questions and comments concerning your investments, and we certainly appreciate the trust and confidence you have placed in us. Thank you for your business!
Authored by: Chad A. Sander,CFP®
Direct Phone: 812-602-6302
“Only dead fish swim with the stream”
– Thomas Malcolm Muggeridge (March 24, 1903 – November 14, 1990) was a British journalist, author, media personality, and satirist. During World War II, he worked for the British government as a soldier and a spy.
When the economic pendulum swings to one particular extreme the way we have seen as of late, it can be very easy to lose focus on what is really most important to all of us in this life. As an example, if you could earn an extra 1% return on your investments this year but in the end did not accomplish a key lifetime goal (example- retiring when you want or helping a child or grandchild through college) would you consider that a success? Many people would respond with a resounding “NO!”
What can happen when we lose focus on life’s goals is “investment performance chasing” with almost no attention being paid to whether we are on the right track or not to accomplish our goals. Financial Planning, as our firm performs it for many of our clients every single day, helps to keep the end goal in mind. In our opinion it is most important to ensure that you’re living the retirement lifestyle you desire, educating the next generation, meeting your charitable goals and ultimately creating the legacy you desire.
Yes, it is very difficult to keep the long-term big picture in mind when the media outlets are practically screaming at us about each day’s market returns. Does that mean it is any less important? Not a chance! In fact, the more we are distracted from our most meaningful life goals by the short-term focus on investments, the more we are at risk of getting off track, and perhaps so far off track that the things we must do to correct course can become very dramatic.
Know that our wealth planning team will continue to work tirelessly to focus on securing what will matter most for our clients in 10, 20 and 30 years. For each of us, we believe our family, community and legacy will leave a mark on this world much more than all these other things combined.
Authored by: N. Perry Moore, CBEC™, CFP®, ChFC®
Direct Phone: 812-602-6306
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