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U.S. stocks have been rock-solid this year. Until recently.
Up until the end of April, the U.S. was performing in line with world’s major markets. But as the U.S.-China trade war intensified, it started to outperform significantly.
At the end of September, the S&P 500 was up nearly 10 percent year-to-date. That’s compared to a 2 percent decline for the MSCI Europe Index, a 7 percent decline for the MSCI Emerging Markets Index and a 9 percent drop in the MSCI China Index.
But since then, those gains have vanished into thin air. The S&P 500 has lost 9.5 percent since its high set on September 20, and is now down 0.3 percent for the year.
As you can see in the chart above, the MSCI China, MSCI Emerging Markets and MSCI Europe indices have all lost between 10 and 20 percent since the start of 2018.
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Being down 0.3 percent compared to double-digit losses is still an impressive outperformance. But in the meantime (and part of the reason for the underperformance of stocks), you could be earning nearly 2.6 percent (risk-free) in a 12-month U.S. Treasury.
Interest rates have been rising, and are expected to continue going up if we’re to believe the Federal Reserve. This new reality of higher interest rates competes with the attractiveness of investing in stocks – given that we’re in the longest-running bull market in history, valuations are stretched and it’s becoming more difficult for the market to sustain its uptrend considering the headwinds presented by rising interest rates.
This is when diversification matters
There’s an old stock market saying that everyone’s a genius in a bull market.
But when the markets go the opposite direction – and they always do, eventually – investors quickly see the danger of having all their eggs in one basket.
For example, tech investors during the internet mania of 2000 lost as much as 90 percent of their investments as the dot-com bubble burst. But investors in the Chinese stock market were largely insulated from the fallout of the tech carnage on Wall Street. During the same period, the Shanghai Composite index fell just 7.2 percent.
Around the same time, U.S. home prices collapsed nearly 30 percent after the housing bubble burst in 2008. Gold, though, nearly tripled between July 2006 and February 2012.
So it’s important not to invest in just one type of asset. Owning gold, bonds and real estate, as well as stocks is key to a properly diversified portfolio. And, of course, have some cash on hand – it’s the ultimate hedge against falling markets.
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You should also make sure to consider valuation. Investing in overvalued markets increases your chance of facing unwanted and unexpected losses in your portfolio. And the U.S. market has been one of the most overvalued markets in the world on a cyclically-adjusted price-to-earnings (CAPE) basis. Only Ireland and Denmark have CAPE ratios higher than the U.S.
While expensive markets can always stay expensive for a long time, sooner or later, these markets revert back to levels closer to their historical norms. This is especially true for markets where nearly all the good news has been discounted.
Finally… consider growth. In the 20 years I’ve been following the markets, one major denominator of markets that delivered strong results was elevated economic growth. For example, in the early 2000s, growth was elevated in China (GDP growth averaged 10.3 percent from 2000 to 2009), and investors who weren’t invested in Chinese stocks missed out on large returns. The Shanghai Composite Index grew by a compound annual growth rate of 9 percent during this 10-year period.
But growth is now shifting to other parts of the world, particularly in emerging markets like Vietnam, Thailand, the Philippines and India. Their economies are being driven by new and large middle classes, favourable demographics that ensure an abundant supply of affordable labour, and significant inflows of foreign investments.
What this all means is that, if you’ve been relying too much on one particular market or asset for your investments, it makes sense to be diversified. Bull markets don’t go on forever, while out-of-favour markets today will have their day in the sun.
Editor, Stansberry Pacific Research