Investment

Will Global Diworsification Ever End?

Every serious investment textbook on the planet recommends two things.

First, buy cheap stocks.

Academic studies have confirmed time and time again that, over the long term, value beats growth.

Second, diversify your stock investments across the globe.

This is the formula that helped global investing pioneer Sir John Templeton make his fortune.

Alas, emulating Templeton’s strategy over the last decade or so just hasn’t worked.

But market extremes like this don’t last forever. One day, foreign stocks will begin to catch up to their U.S. rivals.

But predicting exactly when this will happen is a mug’s game.

The U.S. Stock Market: First Among Unequals

The outperformance of the U.S. stock market compared with its global rivals over the past decade has been astonishing.

I track the performance of 47 global stock markets on a daily basis through country-based exchange-traded funds (ETFs).

I prefer to look at the Vanguard Total Stock Market Index Fund ETF (NYSE: VTI) because it includes small and midcap stocks and provides a more complete view of the U.S. market than, say, the S&P 500.

Over the past decade, the iShares MSCI Emerging Markets ETF (NYSE: EEM), the best-known proxy for the fastest-growing subset of foreign markets, generated average returns of only 3.6% per year.

That performance trails the Total Stock Market ETF’s 10-year average annual return of 14.7% by a whopping 11.1% per year.

Emerging Markets vs US Market

Among the 47 global markets I track, the U.S. – as reflected by the Total Stock Market ETF – ranked No. 1 over 10 years, No. 3 over five years (behind the Netherlands and Taiwan) and No. 4 over the last three years.

Returns in the U.S. stock market over the past 15 years have crushed all rivals.

When Amazon (Nasdaq: AMZN) soon joins Microsoft (Nasdaq: MSFT) and Apple (Nasdaq: AAPL) in the $2 trillion-market-cap club, the U.S. will have three companies that individually match the annual GDP of Italy – the world’s eighth-largest economy.

Put another way, the U.S. will have three companies with market values high enough to earn them a place among the top 10 global economies.

Such complete domination is historically unprecedented. Only the bubble economy of late 1980s Japan comes close.

No wonder the U.S. stock market is by far the most overvalued major stock market in the world.

U.S. vs. the World

The cyclically adjusted price-to-earnings (CAPE) ratio measures the current price of a market divided by the average of 10 years of earnings, adjusted for inflation. Think of it as a long-term price-to-earnings (P/E) ratio.

Today, the U.S. stock market trades at a CAPE ratio of 38.4. That’s more than double its historical average of 16.84. Only at the peak of the dot-com boom was the U.S. market more overvalued.

How does the U.S. market’s valuation compare with other stock markets around the globe? Let’s look at an ETF that invests in the cheapest markets in the world.

The Cambria Global Value ETF (CBOE: GVAL) tracks a proprietary global value index.

The index begins with a universe of 45 countries located in both developed and emerging markets. The fund then selects the top 25% cheapest country stock markets.

The top five countries in the portfolio are Poland, Austria, Italy, Colombia and Greece.

Today, the stocks in the Global Value ETF boast an average P/E ratio of 13.64 and a price-to-book ratio of 0.96.

That compares with a P/E ratio of 25.6 and a price-to-book ratio of 4.1 for the Total Stock Market ETF.

U.S. vs. the World in the Decade Ahead

So what can we expect from U.S. and foreign markets in the coming 10 years?

Academic studies have confirmed that the CAPE ratio is a reliable indicator of future actual stock market returns.

And that applies not only in the United States but also in developed global and emerging markets.

Few things are predictable in investing. But one of them is the “reversion to the mean.”

As happened with England’s South Sea Bubble of the 1710s… the Japanese asset bubble of the 1980s… and the dot-com bubble of the 1990s… valuations hit extremes and the bubble eventually bursts.

Whenever valuations get too far out of whack, it’s only a matter of time before they snap back in line with their longtime average.

To put it in stock market terms… Cheap global stocks will get more expensive and expensive U.S. stocks will get cheaper.

So when exactly will global stocks begin to topple the U.S. stock market from its Olympian heights?

I can’t say for sure. But rebound one day they will.

Make sure you are ready for it.

Good investing,

Nicholas

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