Why You Have Way Too Much Invested In U.S. Stocks

It isn’t just retail investors – professional investors allocate most of their assets to their home countries as well. 

A home-country bias is compounded by another unfortunate tendency that most investors exhibit: favoring market indices weighted by market capitalization.

Why is market-cap weighting so problematic? Market-cap weighted indexes are constructed using only one variable – size – which is determined by price. Below is a chart from Ned Davis that demonstrates how investing in the largest company by market cap in the U.S. has performed historically. It’s a terrible idea!

Figure 3 – Owning the highest capitalization S&P 500 stock

Source: Research Affiliates, Ned Davis Research. S&P 500® index is proprietary to and is calculated, distributed and marketed by S&P Opco, LLC (a subsidiary of S&P Dow Jones Indices LLC), its affiliates and/or its licensors and has been licensed for use. S&P® and S&P 500® are registered trademarks of Standard & Poor’s Financial Services LLC, and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC. © 2014 S&P Dow Jones Indices LLC, its affiliates and/or its licensors. All rights reserved.

In Rob Arnott’s June 2010 issue from Research Affiliates, Too Big To Succeed, he examined how the largest market-cap company in each sector performed relative to its peers. (A similar study was featured in Mosaic: Perspectives on Investing by Mohnish Pabrai.)

From Arnott’s letter:

Now, Arnott manages billions using indices that are not market-cap weighted, but the argument is certainly persuasive. (He also co-wrote the very good book The Fundamental Index: A Better Way to Invest.)

When overvalued assets grow to be bigger and bigger parts of a market – or become the market – you no longer want to invest in that market or stock. That’s the beauty of capitalism and creative destruction. When a company grows to be one of the most successful companies in the world, that success places a large target on its back. When Apple made the world-changing iPhone, companies around the world took notice, and pretty soon Samsung and others were making their own phones to compete with it.

The biggest failing of market-cap-weighted buy-and-hold investing is that it ignores valuations. Below is Japan’s historical 10-year cyclically adjusted price-to-earnings (CAPE) ratio, which illustrates by far the biggest bubble ever seen. The U.S. Internet bubble in 1999 (CAPE ratio of 45) was half the size of Japan’s. Is it reasonable to believe that it was just as good of a time to invest in Japan in 1989 as it is now? 

Source: Global Financial Data

Japan’s stock market rose to account for nearly half of the world’s market cap. And if you believed in the efficient market, you would have invested half of your equity allocation in Japan.But  Japan returned approximately -2% per year from 1990-2010, including more than 20 years of negative returns. A value-driven approach works not just by investing in the cheapest markets, but also by avoiding the most expensive.

What is the biggest country in the world by market cap now? The U.S., with nearly half of global stock-market capitalization.

Figure 5 shows the cheapest and most expensive countries in the world. Notice that the U.S. is one of the most expensive countries in the world.

Figure 5 – Five Cheapest and Five Most Expensive Countries, May 2014

If you look at where we stand today with world valuations in the chart below, the U.S. is actually above the upper end of the range for expensive countries. This chart could be used to help guide when to allocate more to the U.S. versus the rest of the world. The U.S. was cheap relative to the rest of the world in the early 1980s, which also happened to be the start of the long bull market. The late 1990s saw the U.S. near the top of the range, which preceded the bear market that began in 2000. 

Will the current overvaluation signal another bear or perhaps a time to shift more assets to foreign markets? Time will tell.

Figure 6 – CAPE ratios of expensive, cheap, USA and all countries

I examine how to form portfolios of the cheapest countries in a new book, Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market.

The bad news is the U.S. stocks are expensive, although not in bubble territory.  I expect U.S. stocks to return about 4% per annum for the next 10 years.  The good news is most of the rest of the world is quite cheap. Here are a few actions investors can take to improve the future returns of their equity portfolio:

1. At a minimum, allocate your portfolio globally reflecting the global market-cap weightings. For a U.S.-based investor, that means allocating 50% of your portfolio abroad.
2. To avoid market-cap-concentration risk, consider allocating along the weightings of global GDP. This would mean closer to 80% in foreign stocks.
3. Ponder a value approach to your equity allocation. Consider overweighting the cheapest countries and avoiding the most expensive ones. Currently, this would mean a low or zero allocation to U.S. stocks. This does not mean simply picking one or two countries, but rather a basket of the cheapest countries – 10 is a reasonable number.

For U.S. investors, how many of your stocks are in the domestic market? Once you account for the fact that the U.S. is one of the more expensive markets around the globe, it could be a good time to rethink your stock allocation. 

Meb Faber is the chief investment officer of Cambria Investment Management, LP and author of the newly released Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market.  More information can be found at www.cambriafunds.com and www.mebfaber.com.

Read more articles by Meb Faber