Introduction to International Diversification
In the ever-evolving landscape of global investing, the allure of the U.S. stock market has been undeniable, driven partly by the meteoric rise of large-cap technology stocks. These stocks have commanded eye-watering valuations, prompting investors to increase their exposure to U.S. equities significantly. While this strategy has borne fruit in recent years, it presents considerable risks, chief among them being overvaluation and market concentration. Such risks underscore the importance of international diversification—a strategy that allocates investments across various global markets to mitigate reliance on any single economy or currency.
Historical Perspective and Current Trends
Historically, the dominance of the U.S. stock market is not a constant. For example, during the 1970s, 1980s, and 2000s, U.S. equities generally underperformed compared to their international counterparts. This variance in performance across decades highlights the cyclical nature of market leadership and the benefits of a diversified investment portfolio that can capitalize on different regional dynamics over time.
The Prevalence of Overvaluation and Bankruptcy Risks
Before delving deeper into the specifics of market valuations, it is imperative to address the two predominant risks in equity markets: overvaluation and bankruptcy. Overvaluation occurs when stock prices exceed their intrinsic values, a scenario often propelled by excessive investor optimism and speculative trading. Bankruptcy risk, on the other hand, pertains to the potential for companies to fail financially, which can lead to considerable investor losses. Both risks highlight the critical need for a diverse investment portfolio that not only spreads out economic and financial exposure but also mitigates the impact of adverse movements in any single market or stock.
The U.S. Valuation Problem
The impressive performance of the U.S. market since the 1990s can largely be attributed to expanding valuation multiples rather than fundamentally superior growth. Between 1990 and 2022, U.S. stocks outperformed the MSCI EAFE Index by an average of 4.6% annually, primarily driven by rising valuations. Initially valued at half the level of their EAFE peers in 1990, by 2022, U.S. stocks commanded valuations 1.5 times higher. When adjusted for these valuation disparities, the apparent outperformance diminishes significantly, suggesting that the U.S. market’s returns were largely fueled by increased investor willingness to pay higher prices for stocks, an inherently unsustainable trend.
Graph Analysis: Valuation Disparities Between Markets
As illustrated in the graph below, using the CAPE Ratio (the CAPE ratio is a p/e ratio that uses 10-year average earnings) for a valuation metric there is a stark contrast in valuation trends between the U.S. and other major markets such as Europe, Hong Kong, and Singapore. Over the past few decades, we can observe periods where the U.S. market valuation significantly outstrips those of other regions, particularly during the recent tech-driven market rally. However, the graph also shows periods where these markets have either outperformed or provided better value compared to the U.S., highlighting the cyclical nature of market valuations and the potential for international diversification to capitalize on these disparities.
Source: Shiller CAPE data, 12/31/1981 to 6/28/2024
Opportunities in Emerging and International Markets
With U.S. markets currently sporting high valuations, it is an excellent time to be looking at emerging and international markets that offer compelling investment opportunities. These markets often boast more attractive valuations and the potential for significant returns, especially when global markets experience corrections or when U.S. valuations revert to more historical norms. Countries in Southeast Asia, Europe, and Latin America, in particular, present promising prospects due to their favorable demographics, growing economies, and expanding consumer bases.
Risks of Overweighting U.S. Stocks
Investors heavily concentrated in U.S. stocks face significant exposure to a downturn, particularly within the technology sector, which has disproportionately driven recent market gains. Such concentration heightens the risk of substantial losses in the event of a tech-sector correction or broader economic downturn. Additionally, the U.S. economy itself faces numerous challenges, including structurally higher inflation, geopolitical tensions, and potential recessions, which could undermine the sustained performance of its stock market.
Conclusion: The Strategic Necessity of Global Diversification
While the U.S. stock market has provided robust returns in recent years, its elevated valuations and sectoral concentrations pose substantial risks. A strategically diversified investment approach is not merely optional but essential in today’s complex global financial landscape. By broadening investment horizons beyond U.S. borders, investors can enhance their potential for risk-adjusted returns and safeguard against market volatility and economic downturns. In essence, HCM believes it is unwise to anticipate a continuation of the U.S.’s triumph over the last 15 years, which was largely driven by escalating multiples, and now is a particularly poor moment to misinterpret historical lessons.