Every weekday morning Jim stops at his favorite coffee shop. He orders a latte and settles into a chair to subtly watch people. He isn’t a creepy dude. He’s just social and curious. There’s a young couple at another table that Jim sees most days. But they don’t appear happy, so they might have had a disagreement. Two policemen are ordering coffees to go, and a local college professor, whom Jim speaks to once in a while, appears to be reviewing a lesson on his laptop.
There’s a similar vibe at the café across the street. They also serve great coffee and Jim occasionally meets friends there on weekends. But as a man of habit, he prefers his usual, morning place. Several years ago, the coffees at each café were priced about the same. But then prices began to rise at his favorite spot. His lattes were $4 a couple of years before. But they’re now $8. Meanwhile, lattes across the street are just $5.
Jim is like most people. He’s a creature of habit with set routines. And paying $8 instead of $5 for his daily cup of coffee won’t break his bank.
However, something similar has happened with US stocks. Historically, their price-to-earnings ratios (a measurement of expensiveness) were similar to international stocks. But since 2009, that has changed a lot.
Below, the blue line represents the CAPE ratio for US stocks from January 1983 to January 2021. This might look like a stock market chart, but it isn’t. It’s a measurement of how expensive stocks were, at different times, relative to business earnings. As professor Robert Shiller found, when stocks trade significantly higher than their historical CAPE ratio, it usually indicates a weak decade ahead.
For example, notice the peak in 1929. US stocks hit a CAPE ratio of about 30 times earnings. If someone invested $100 in US stocks in 1929, it would have been worth just $77 ten years later. They didn't earn a real return (adjusted for inflation) until 1944.
Next, look at the peak in 1965. US stocks hit a CAPE ratio of about 25 times earnings. After that peak, it took 17 years for US stocks to post an after-inflation return, with all dividends reinvested.
Now, look at the sky-high level in 2000 when the CAPE ratio hit 44 times earnings. It took US stocks 13 years after that point to post an after-inflation profit, including reinvested dividends.
Robert Shiller’s CAPE Ratio (Cyclically Adjusted Price-to-Earnings)
That’s why, with US CAPE ratios recently hitting 38.8 times earnings, it’s arguably crazier than a $100 cup of coffee. However, that doesn’t mean you should sell US stocks. Historically, the CAPE ratio has been the best predictor of future decade returns. When stocks are priced far higher than their historical average, a bad decade typically lies ahead. In contrast, when stocks trade far below their historical average, it usually bodes well for stock returns over the next ten years.
But trying to time the market, based on CAPE ratios, is as smart as juggling cups of hot coffee. For example, in 1995, the CAPE ratio hit 25 times earnings. That was the highest level since 1929. However, anyone who sold US stocks in 1995 missed out on a 205 percent gain over the next five years. Nobody can see the future, so don’t sell your US stocks.
This brings me back to those coffee shops. Jim’s coffee shop is now expensive and has been getting pricier every year. The shop across the street has a similar social vibe and it sells equally great coffee at a much cheaper price. I’m not saying Jim should ditch his coffee shop for the one across the street. But if he alternates days between the two cafes, it would be easier on his wallet.
That second café, metaphorically, represents international developed and emerging market stocks. They are cheap. As such, if they aren’t already part of your portfolio, make them part of your long-term plan.
Below, you can see a chart showing historical CAPE ratios for US stocks (in orange) and global stocks (in blue) from January 1983 to January 2021. Notice how they usually went hand in hand. However, US stocks became more expensive (relative to earnings) after 2009. But the global stock market index didn’t become much more expensive. That doesn’t mean global stocks didn’t earn a profit after 2009. They did. A $10,000 investment in global stocks in 2009 would have quadrupled in value to about $42,000 by early December 2021. But unlike US stocks, global stocks did not become much more expensive, relative to business earnings.
It’s important to note that the orange line doesn’t solely represent international developed market stocks and emerging market stocks. Such stocks are commonly known as “international stocks.” But global stocks, as represented by the orange line, represent international stocks and US stocks. If the chart below had a third line, representing international stocks in isolation, that third line would show such stocks are even cheaper than what you see represented by the blue line below.
At some point, stocks will crash. It might be this week. It might be five years from now. But crashes are normal, especially when stocks are priced sky-high.
When that crash occurs, everything will drop: US stocks and international stocks will both plunge. But after a crash, cheaper stocks recover faster and rise far further. That’s why if your portfolio isn’t globally diversified with exposure to international developed and emerging market stocks, sort that out today. Otherwise, your $100 cup of coffee could give you a nasty burn.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas