I hope you are all enjoying this unusually mild summer in Atlanta!
A question I’ve been getting from friends and clients is along the lines of: “Is the market due for a down turn?” Or, “Is the market over-heated?” What most people consider “the market” is really just the 500 largest U.S. companies (S&P 500).
But a truly diversified portfolio is really a collection of several markets:
- The U.S. Bond market is a collection of different types of bonds which behave very differently than stocks.
- Small Cap US Stock market are a large collection of smaller companies that behave differently from large companies.
- The International Stock market is a huge collection of foreign companies from all over the world (China, England, Brazil, etc.).
- Alternative investments are things that don’t fit the definition of a stock or bond (For example: Real Estate Investment Trust also known as REIT.)
To answer where the stock market is due for a downturn, we need to talk about several markets:
- By some measures the US stock market does look like it may be a bit frothy. US Large cap stocks have had a 9-year bull market (where stocks go up in value). Together with our friends at Steinberger Consulting, we look at a lot of different measurements to determine how to invest. One of these is the Price to Earnings Ratio (P/E) for American stocks which is currently about 30 to 1 versus the historical average of about 18 to 1. With this measurement, the higher the ratio the more expensive, and potentially over-valued, stocks appear. The counter argument here is that the low interest rate environment explains some of why the P/E ratio is high.
- International stocks have a P/E of 15 to 1 (for developed countries like France, Japan, etc.) and 13 to 1 for Emerging Markets (e.g. China, Brazil, etc.). There are different reasons why the P/E ratio is lower in international markets but generally speaking international stocks look to be “on sale” right now.
- The current yield on the 10-year bond is 2.2%.
- The low interest rate environment has been very persistent despite the Fed’s efforts to lift short term interest rates.
- Our bond portfolio remains very diversified among: US Govt Bonds, Corporate Bonds, Inflation Protected bonds (bonds that do better when inflation rises) and Foreign bonds (e.g. German government bonds, a Japanese corporation’s bonds).
So how does Chastain invest in this environment? Historically, when stocks have had long bull runs, they tend to be followed by long bear markets. In moments like this, it is even more crucial that we own companies domiciled outside the US especially given the uncertainty around valuations. Translation: Invest in stocks of countries in Europe, Asia, and South America.
As always, markets are unpredictable and we truly do not know how this will play out. This is not a prediction that international stocks will do well or better in the short term, but it does seem prudent to shift some of our portfolio from US stocks to international.
Only time will tell whether there’s justification (if there is one) for higher stock valuations in the US. A prudent disciplined investor should not overreact by selling all positions in the US. However, it does make sense to shift a portfolio allocation out of the US equities markets and pursue an allocation closer to global weights. This means all portfolios need at least 40-50% of the stock investments to be allocated to companies outside the US and Chastain clients should expect to see this in their portfolio.
If all of this is a bit confusing just think of a farmer who needs to feed his family.He plants seeds in several fields hoping that they will all one day yield good crops. If one field isn’t bearing fruit one year maybe another one is. Ultimately, he hopes all the fields will provide food. If he knew for certain which fields would produce the most food he would plant all his seeds there, but he doesn’t. So, he plants a little everywhere and when the soil looks a little more promising in one field maybe he shifts a few seeds to it. He doesn’t want to gamble with his family’s ability to eat, so he keeps his seeds spread everywhere and the family trusts the farmer to water and protect the fields.
I wish you all a happy and fruitful summer!