Despite the fact that being a U.S. equity investor over the past several years has felt glorious, investors should not concentrate their portfolios into indexed U.S. equites, shun diversification and sell international equities.
The paper points out how the S&P 500 has trounced the competition provided by other major developed and emerging equity markets.
“It is easy to see, given the strong performance of U.S. equities in both absolute and relative terms, why many are suggesting they are the only asset you need to own,” the pair write.
Over the last seven years, the S&P is up 173% (15% annualized in nominal terms) versus MSCI’s index for Europe, Australia and the Far East (in USD terms), which is up 71% (8% annualized), and MSCI Emerging, which is up only 30% (4% annualized). Every dollar invested in the S&P has compounded into $2.72 versus MSCI EAFE’s $1.70 and MSCI Emerging’s $1.30, according to the paper.
“So, shouldn’t we … throw in the towel, index all of our equity exposure to the S&P 500, and call it a day? If our goal is compounding capital for the long term, which it is, we would not just say ‘No,’ but something akin to ‘Hell no!’” Montier and Kadnar write.
The pair then take a look at the current valuation of the S&P 500 and at the four components that drive returns – dividends, earnings, price-to-earnings multiple expansion and margin expansion.
The pair find that earnings and dividends have grown as one would expect, but P/E and margin expansion have “significantly contributed to returns” with multiple expansion actually providing the biggest boost of the four.
“If earnings and dividends are remarkably stable (and they are), to believe that the S&P will continue delivering the wonderful returns we have experienced over the last seven years is to believe that P/Es and margins will continue to expand just as they have over the last seven years,” the pair write.
However, the historical record for this assumption is quite thin, according to Montier and Kadnar.
“It is remarkably easy to assume that the recent past should continue indefinitely but it is an extremely dangerous assumption when it comes to asset markets,” they say. “Particularly expensive ones, as the S&P 500 appears to be.”
Rather than U.S. equities, the GMO team much prefers international and emerging market stocks.
“International equities, while not cheap in absolute terms, certainly suffer from poor expectations and much better pricing,” according to Montier and Kadnar. “Their currencies also seem a bit cheaper relative to the dollar. Combine all this with significantly cheaper relative valuations and we believe international equities look a damn sight better than their U.S. counterparts.”
The story is similar within emerging market equities, but the news is actually better. According to the paper, emerging equities have a forecast of 2.9% real growth (local terms) and “cheap currencies to boot.”
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