Have the Stars of the Market Earned their Stripes?

The performance of U.S. stocks over the past decade has been impressive, outperforming other developed countries by ~7% annually. Consequently, investors have no trouble continuing to place (concentrated) bets on the Stars & Stripes. However, from a historical perspective, this recent performance is the exception rather than the rule.

Diversification is one of the few investment principles on which investors (largely) agree. Consequently, investors with an overweighing to the U.S. stock market point to the fact that these companies generate sales on a global scale and that there are many U.S. stocks to bolster diversification. Yet there are important reasons to pursue regional diversification as well:

1. Valuations – U.S. stocks are relatively expensive relative to other regions, implying – ceteris paribus – lower future returns. Even though the largest companies earn much of their profits outside the U.S., the stock price is driven by domestic pricing and is thus sensitive to the domestic investment climate.
2. Concentration – The effective number of stocks in the U.S. stock market has declined as a small number of companies make up a large portion of the total market capitalization. Since 2013, the dispersion in the US index has fallen by almost 60%. This leads to lower diversification, i.e. higher exposure to company-specific risks.
3. International dispersion – While consistency between regional markets has increased, this is driven primarily by greater co-movement in discount rates that calculate the present value of cash flows. There are greater regional differences in the cash flows of companies, which provides diversification benefits. In addition, lowering U.S. stocks in a portfolio provides higher exposure to domestic currency, which protects against strong appreciation of this local currency.

In short, a strong overweight to U.S. stocks based on recent performance does not seem a rational choice given the reduced level of diversification and inconsistent performance based on a historical perspective.

Bluemetric Insight | Diversification within equities has several components, where geographic diversification is an important pillar. Furthermore, one can increase the effective number of stocks by reducing exposure to the largest companies. Systematic investing offers a potential solution for this. Such strategies select securities based on fundamental (e.g. earnings & valuation) or technical (e.g. recent performance) characteristics through predetermined “rules. This leads to a cost-effective solution with potentially higher returns.