We have often spoken about the considerable biases inherent within current market conditions. Investors have enthusiastically invested in a very specific and narrowing range of assets and largely eschewed the wider investable universe. The effects of which can be seen across assets classes and, perhaps more pertinently, in the behaviour of portfolio managers and fund managers. Asset allocators, fund selectors and fund managers have each become more selective, holding less stocks, fewer funds or a diminishing range of assets in an attempt to bolster performance.*
Arguably, the most prominent bias of the last decade has been the popularity of US equities – a popularity that seems to have reached fever pitch this week as the S&P500 touched record breaking heights (2,933.68 at time of writing). This seems a good opportunity for us to discuss our, relative, underweight to the US.
Underweight US – What does it really mean?
Our medium risk products; Portfolio 4 and OEIC 4, have an allocation to US assets of between 15% – 18%. Considering the US makes up almost 1/6th of these portfolios, it may come as a surprise that both are significantly under-weight the geography relative to the peer group.
The IA Mixed Investment 40-85% Shares (the old balanced managed sector and the benchmark for both of our medium risk products) has, over the last decade, seen US assets increase from, on average, 11% to 24% of a balanced portfolio. The chart below demonstrates that this level of US exposure has, traditionally, been reserved for higher risk portfolios (Flexible).
US Weighting Over Time – IA Mixed Assets
This is particularly concerning for medium risk investors who expect a more balanced and diversified approach but have, perhaps unwittingly, become more concentrated – particularly within their equity allocation. It is worth noting then that whilst we are underweight relative to the benchmark, we still invest a considerable amount within US assets, but our allocation is closer to the long run average. Essentially, we remain cautious. The chart below demonstrates how much of an impact this trend has had on the risk profile of the IA 40-85% Sector (Circled in Red below).
IBOSS PMS Portfolios & Benchmarks, 1 Year Scatter Chart
US Valuations – Things look pricey
It is not only the herding effect that leaves us to view US assets with caution. As we have written about for quite some time, US equities look particularly expensive relative to history. Our go-to ratio here is the Cyclically Adjusted Price Earnings ratio (CAPE). This is notoriously unreliable for forecasting market corrections but perversely relatively reliable for being a good indicator of future returns.
The chart below demonstrates a range of CAPE ratios and the 5-year returns preceding those valuations. The take away being that, no matter your opinion, the outlook appears to be poor if history is any guide at all, and as markets hit new records that outlook gets progressively poorer.
Quarter 4 of last year gave us an opportunity to see what could happen if the factors propping up US equities were to falter i.e. the removal of QE and the spectre of rising interest rates. Though the US Central Bank/Fed rowed back on their hard-line stance relatively quickly, the quarter went some way to prove those expensive markets had further to fall with US markets and Technology stocks underperforming considerably over the period. It is worth noting here that US equities saw a drawdown of over -15% and Technology (dominated by US firms) of over -20%.
This period has been somewhat ignored considering the market direction from the start of the year and the prevailing rhetoric now seems to suggest that US equities are a guaranteed winner over almost any period. However, we need only cast our minds back to 2017 where North American Equities were the worst performers despite rising equity markets.
Q4 2018 – MSCI Equity Performance
So why invest in US Equities at all?
With increasing risks from a valuation perspective and the herding effect that has led to a more momentum driven market rally, why do we invest in US equities at all?
The simple answer is that the US equity markets could continue to rise. Trump has applied consistent pressure on the US Central Bank to not only halt interest rate rises but to actively reduce interest rates and continue easing. Powell, whether taking note of Trump or not, responded aggressively to Q4’s sell-off, performing a textbook U-turn relative to his previous comments. This style of intervention could continue to prop up and even propel US equity markets should policy makers remain intent on supporting them. The risk here is that markets have just as much a chance to perform well in the short term as they do to perform poorly.
In summary, we remain invested in US equities but much more cautiously than the peer group, aware that current trends could continue but ensuring that our portfolios remain fully diversified despite the significant market pressure to do otherwise. Howard Marks often remarks on the pendulous nature of Global Equities where markets swing between the states of euphoria and depression. This analogy seems particularly pertinent as we move ever closer toward peak US euphoria.
*This is a trend that is easier to see in equity funds where the funds in vogue tend to own a very small selection of stocks. Using IA Global as an example, 4 of the top 5 most popular global actively managed funds hold under 40 stocks out of a potential 3,241, with an average US holding of 54%. Essentially, you have not been rewarded for taking a more diversified approach to investing.
*Most popular defined as FUM.