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Portfolio Allocation
What is a responsible asset allocation of a portfolio? What
constitutes diversifying abroad? In the US-centric mindset
foreign diversification means having about 5% to 20% of your
assets invested abroad and concentrating 80% to 95% in a single
country the United States. This is a dangerous mindset supported
by myths like, "When the US catches cold the rest of the world
gets pneumonia." The fact is the world economy as a whole is
more stable than the US economy. For example, in the 1991
recession there were three quarters of negative growth in the US
economy, there were no quarters of negative growth in the world
economy. But you can count on the US-centric financial media to
perpetuate the myth by drawing attention to countries that are
doing worse whenever the US economy or markets struggle.
Americans have the impression that US stock
market returns are superior, when for the last 33 years they are
actually about average. Within that 33 years there was an 18
year period of below average US returns, followed by a 10 year
period of superior performance, capped by a 5 year span of
average return. If my analysis is correct we are faced with a 10
to 20 year period of significant under performance characterized
by 0% return on US equities after inflation.
If you have a world wide investment perspective
the investment allocations between the US and the rest of the
world should be reversed from those of a US-centric perspective.
To see why lets take a look at the US place in the world
economy.
 The
US has about 5% of the world’s population and about 6% of the
natural resources. It produces about 20% of the world’s gross
domestic product ("GDP") on a purchasing power parity basis, or
about 27% if you use current exchange rates to measure relative
GDP. Currently stocks in the US have about 56% of the market
capitalization, or value, of all the publicly traded stocks in
the world.
From a world wide perspective if you were going
to weight your stock market investments by stock market
capitalization you would currently own 56% in US equities and
44% in equities of other countries. If you were going to weight
by the relative production of goods and services you would have
about 20% of your investments in the US and the rest in other
countries. This is if you were going to have neutral weighting.
However there is a strong case to underweight the US market.
Just from the data in the pie charts above there
are a several important observations. The positive one is that
for the US to produce 20% to 27% of the world’s GDP with only 5%
of the population makes the US the most productive nation on the
planet. The other observations are downright discouraging. The
seven percentage point gap between the US share of world GDP
measured using purchasing power parity verses exchange rates
suggests that the US dollar is about 35% over valued. The 56% of
market capitalization suggests US stocks are significantly
overvalued above and beyond the overvaluation of the currency.
I don’t know what the US share of the world’s
stock market value should be. I suspect that a higher proportion
of US GDP is produced by publicly traded companies than is true
in most foreign countries. So if 20% of GDP is produced in the
US I’ll offer a shoot from the hip estimate that the US should
have 27%-30% of the world’s market capitalization.
In 1988 the US stock market performance hit a
bottom relative to the world stock market. The US then produced
about 30% of the world’s GDP and had about 24% of the stock
market valuation. This was when the Japanese stock market was
bigger than ours. At that point our market was obviously a great
value. Now when the US share of stock market valuation is two or
almost three times as high as its share of GDP it almost
certainly is a terrible time to hold US equities.
Which would you expect to be a better use of
your investment dollars: own a small fractional interest in
about 27% - 30% of the profits of the world’s companies, or to
own a slightly larger interest in about 70% - 73% of the profits
of the world’s corporations? Right now investing abroad gives
you a chance to own a larger share of bigger profits than
investing in the United States.
In my estimation in the next 5 years the US
stock market return will finish about 29th out of the 50
countries Economic Leads is tracking. Does it make any sense to
concentrate 80% to 95% of your portfolio in a country whose
investments are likely to under perform and may be priced at
twice its real value. Is it time to change your investment
perspective from US-centric to world wide? Such a change is
highly likely to be more profitable and have less downside.
One argument I have heard for keeping most
investments in the US is that, "I live here and the things I buy
and use are in this economy." That is partially true, but less
so than you might think. For example, the price of oil and coal
is set in the world market. So the price you pay for energy is
based on what happens in the world economy. The prices for most
agricultural commodities particularly things that can be shipped
and stored are set in the world markets. Most manufactured goods
compete in the world market place. If the dollar drops 35% and
the cost of imported cars rises 35%, domestic car prices will go
up accordingly. If the dollar does drop 35% and we start a
period of exporting more than we import, wages in export
industries should be driven up and force other industries to
increase wages.
What happens in the US is intricately woven into
the world economy. To act as though that other 80% of the world
economy is not out there affecting you and your future is great
folly. If you want to invest from a standpoint of market place
reality you have to have a world wide perspective. When the US
has a long period of superior or average performance as from
1988 to 2003 investing with a US-centric perspective is not
costly and even beneficial. Investing from a US-centric
perspective from 1969 to 1988 would have cost you two thirds of
the total return. The cost of a US-centric investment
perspective in the next 15 years will probably be at least
equally costly.
The foregoing is the opinion
of John Early an Investment Advisor there is no guarantee that
his analysis of historical data and trends enable him to make
accurate forecasts of the future. The data presented is taken
from sources believed to be reliable, but its accuracy cannot be
guaranteed. Past performance does not indicate future results.
This is not a recommendation to buy or sell specific securities.
This is not an offer to manage money.
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