Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market. Mebane is co-founder, chief investment officer and portfolio manager at Cambria Investment Management. He's an accomplished quantitative analyst who applies his research practically. Follow Mebane's Twitter feed and visit his excellent blog.
Even if you decide not to invest in the cheapest countries in the world, it is at least worth thinking about your global stock allocation with a value mindset. And why is that?
Most investors around the world invest most of their assets in their own stock market. This is called the “home country bias,” and it occurs everywhere. Below is a chart from Vanguard that details the effect in the US, the UK, Australia, and Canada.
FIGURE 1 – HOME COUNTRY BIAS
Below is a chart from the JPMorgan Guide to the Markets. It details the US as a percentage of market cap (46%) and GDP (19%).
For US investors, how much of your stocks are in the US domestic market? Once you account for the fact that the US is one of the more expensive markets around the globe, it might be a good time to rethink your stock allocation. A value approach works not just by investing in the cheapest markets, but also by avoiding the most expensive.
FIGURE 2- WEIGHTS IN MSCI ACWI INDEX & SHARE OF GLOBAL GDP
Why is market cap weighting so problematic in the first place? Market cap weighted indexes have only one variable - size - which is largely determined by price. Below is a chart from Ned Davis that demonstrates how investing in the largest company by market cap in the US has performed historically. Is that a good idea?
FIGURE 3- OWNING THE HIGHEST CAP S&P 500 STOCK
In Rob Arnott’s June 2010 issue from Research Affiliates, titled “Too Big To Succeed,” he examines how the largest market cap company in each sector performs relative to its peers.
(Another study was featured in the book, Mosaic: Perspectives on Investing by Pabrai.)
From Arnott’s letter:
We find the leader in any sector underperforms the average stock in its own sector by 3.5% in the next year … and the next year … and the next year. As Table 1 shows, the damage doesn’t really slow down for at least a decade, as the top dog in each sector lags its own sector by 3.3% per year for the next decade!
From these results, one might conclude that an investor could do rather well by investing in the Russell 1000, minus its 12 sector leaders. Better still, perhaps we should exclude all of the companies that have been sector leaders any time in the past decade because the performance drag for the top dogs tends to persist for a decade or more. These stocks typically comprise about one-fourth of the Russell 1000! If these stocks suffer a 300–400 bps shortfall in most years, one could outperform the index by nearly 100 bps per annum merely by leaving the top dogs out, cancelling the corrosive influence of competitors, populists, and pundits.
Now, Arnott runs billions on indexes that are not market cap weighted, but the argument is certainly persuasive. (He also co-wrote the very good book titled The Fundamental Index: A Better Way to Invest.)
When overvalued assets grow to be bigger and bigger parts of a market - or become the market, you no longer want to invest in that market. That is the biggest failing of market cap weighted buy and hold - it ignores valuations. Below is Japan’s historical CAPE ratio., which mentioned earlier, is by far the biggest bubble we have ever seen. Our Internet bubble in 1999 (CAPE ratio of 45) was half the size of Japan’s. Is it reasonable to believe that it is just as good of a time to invest in Japan in 1989 as it is now?
FIGURE 4 – JAPAN CAPE RATIO OVER TIME
Japan rose to be nearly half of the world’s market cap. And if you believed the “efficient market,” you just went along and invested half of your stock allocation in Japan. Japan returned approximately -2% per year from 1990-2010. That is over 20 years of negative returns.
What is the biggest market cap country in the world now? The US, at nearly half of the global stock market capitalization. What is the most expensive country in the world? (Yep, same). Now there is a big caveat, and that is the US isn’t in a bubble. But the US isn’t cheap like the rest of the world. So you may still be depriving yourself of better opportunities elsewhere.
Below is a great piece from Alliance Bernstein that examines other market cap weighted indexes. Note how bad it is to invest in these bubbles.
Their table is flashing a warning about one of our least favorite assets, US high yielding dividend stocks. (This is also a good illustration of how asset flows can alter an investment strategy. Namely, dividend stocks have historically worked due to their value characteristics, but as money has flowed into the stocks chasing yield, they are trading at historic premiums to the overall market. We discussed this a bit in our book Shareholder Yield, and OSAM has a good piece on the subject in a December 2013 article titled “The Myth of the Most Efficient Market.”)
FIGURE 5- PROBLEMS WITH CAP WEIGHTED INDEXES
Passive and active are meaningless terms since we take the position that everything is active. There are rules for buying, selling, and rebalancing. It is ironic that the largest and most famous index, the S&P 500, is really an active fund in drag. It has momentum rules (market cap weighting), fundamental rules (four quarters of earnings, liquidity requirements), and a subjective overlay (committee input). Does that sound passive to you?
However, most of the early indexes were built to be representative of the marketplace. So while indexing was revolutionary, market cap weighting was not necessarily the best approach for managing money. Over the past thirty years we have seen an amazing amount of research that has shown simple ways to construct mechanical portfolios, i.e., indexes that outperform these market cap indexes. Simple factors that take into account value, momentum and trend, and carry have been applied within and across asset classes to form more robust portfolios. Second generation indexes have improved upon the first generation (commodities are a great example here).
Below O’Shaughnessy Asset Management put together a piece titled, ”Combining the Best of Passive and Active Investing” that is well worth your time.
FIGURE 6 - BEATING THE INDEX BEFORE AND AFTER COSTS
If you look at where we stand today with world valuations, the US 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 US versus the rest of the world. The US 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 to follow. The late 1990s saw the US near the top of the range which also preceded the 2000 bear market. Will the current overvaluation signal another bear or perhaps a time to shift more assets to foreign markets? Time will tell.
FIGURE 7 – CAPE RATIOS OF EXPENSIVE, CHEAP, USA, AND ALL COUNTRIES
As a quick summary, there are a few actions investors can take to improve the future risk-adjusted returns of their equity portfolio.
1. At a minimum, allocate your portfolio globally reflecting the global market cap weightings. In the US, 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 60-80% in foreign stocks.
3. Similarly, 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 US stocks. Note: This does not mean simply picking one or two countries, but rather a basket of the cheapest countries – 10 is a reasonable number.
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