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

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.