Imagine this: You’re 16 years old. You’ve moved to a different district and it’s your first day at school. You walk into a cafeteria full of strangers. One friendly teen walks up and says hello. You grab on to this person like bark to a tree. Dozens of other kids go to this school, but they don’t appear as nice. They don’t smile as broadly and you haven’t heard great things. Your friend, however, is thoughtful, funny, dependable, and he pumps up your ego. He’s your best friend for years, until one day, he isn’t.
At first, he starts to ignore your texts. Then he humiliates you in public. Then he steals your bankcard and almost wipes you dry. Your biggest mistake, however, wasn’t becoming friends with this person. The mistake, instead, was ignoring everybody else. Now that you’ve been burned, there’s nowhere else to turn.
For many investors, this sounds familiar. They often fall in love with a favorite stock or market sector. They make fabulous profits, year after year, so they pat themselves on the back. But one day, those stocks or that sector turns and falls hard. It happened to tech (electronics) stock investors in early 1960s, and once again in 2001. Investors who weren’t diversified paid a hefty price.
Another painful period might be coming soon. U.S. stocks are soaring. Technology stocks, once again, are priced in the stratosphere. Nobody can predict how stocks will perform over the next year—or five. But Yale University professor, Robert Shiller, has a chillingly accurate long-term barometer.
Professor Shiller measures cyclically adjusted price-to-earnings ratios, or CAPE ratios. It averages inflation-adjusted corporate earnings over a period of time. It’s a tougher measurement than a typical PE ratio because it doesn’t measure productivity over just a single year. That means an unusually good year or bad year can’t skew the measurement.
Shiller found that when a stock market trades significantly higher than its historical CAPE level, a disappointing decade usually follows. In contrast, when stocks trade far below their historical CAPE levels, it’s a sign of strong profits for the next ten years.
Historically U.S. stocks trade at a CAPE ratio of about 16.9 times earnings. But according to researchers at Star Capital, the U.S. market’s CAPE level for the quarter ending April 30th was 29.8 times earnings. That’s higher than a junkie at Burning Man. It has only exceeded that level once before, in 2001. In the ten years that followed 2001, a $10,000 investment in the S&P 500 would have averaged a compound annual return of just 1.31 percent.
CAPE levels for international developed markets historically average about 20 times earnings. But unlike U.S. stocks, they aren’t currently expensive. Developed European markets, for example, trade at a CAPE ratio of 19.1 times earnings.
Emerging markets are even cheaper. Emerging Asian-Pacific stocks trade at a CAPE ratio of 18.6 times earnings. The BRIC markets (Brazil, Russia, India and China) trade at just 16.2 times earnings.
Like strangers in the cafeteria on that first day at school, international markets have been easy to ignore. U.S. stocks, by comparison, have been all hugs and handshakes. Over the 13-year period ending May 31, 2018, U.S. stocks averaged a compound annual return of 7.74 percent. That compares to international stocks, which averaged a miserly 2.17 percent per year.
But the tide might be turning. On December 19, 2016 I wrote, Why International Stocks Might Have Plenty of Room To Run. Since that date, international stocks have beaten U.S. stocks.
International Stocks Are Moving Ahead
December 19, 2016 – June 1, 2018
|Amount Invested||Sector||Fund||Grew To…|
|$10,000||U.S. Stocks||Vanguard’s S&P 500 (VFINX)||$12,307|
|$10,000||International Stocks||Vanguard’s International Sock Market Index (VGTSX)||$12,602|
|$10,000||Emerging Market Stocks||Vanguard’s Emerging Market Stock Index (VEIEX)||$12,841|
What’s more, international stocks are still much cheaper than their U.S. counterparts. Compared to U.S. stocks, they still have room to run. That’s why you should maintain a diversified portfolio. Include an international stock market index, comprising up to 50 percent of your equity allocation. Include a U.S. stock index too, and a bond market index for added stability.
If you’re working, add money every month and rebalance once a year. Most importantly, never pin your hopes on a single stock market or your favorite market sector. At some point, your friend might stop calling. That’s why it’s best to have more than one.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas