FROM VALENTINE VENTURES – THIRD QUARTER 2018 CLIENT REVIEW
on November 8, 2018
Let’s start with a look at the annual returns of the five main asset classes, ranked annually from best-to-worst, between 2003-2009, with particular attention to the differences between US stocks and foreign stocks—the annual return for US stocks is the red box, and the annual return for foreign stocks is in the blue box.
As you can see, for the period shown foreign stock performance was notably better than US stock performance. In the process, foreign stocks become more “expensive” on a valuation basis, leading, eventually, to investors pulling their money from foreign stocks in favor of the US ones, which lead to the following mean-reverting cycle:
We started to lean-foreign in our portfolios in the latter part of this cycle (around 2014-2015), and 2017 looked like the beginning of the new foreign-led cycle.
And then we entered 2018.
As mentioned, three primary drivers led to a resurgence of US stock dominance: a cut in the corporate tax rate, tough negotiations with our trading partners, and continued US economic strength. In fact, the US market is the best performing market in the world this year!
So are we “wrong” to be tilting-foreign? No. We’re early. The crowd is overwhelmingly pro-US and as a contrarian investor, I’m convinced that the turn in the cycle is imminent.
Check this out:
This chart displays the result of a survey of global fund managers–nearly 100% say they are “over-weighted” to US equities versus foreign. It’s the most bullish managers have been on US stocks–this is a massive contrarian signal. When the crowd all believes one thing, I believe the opposite.
Consider the disparity between market “expensiveness” (valuation) comparing the US to the foreign developed markets (Western Europe, Japan, Korea, Australia, etc.) and the emerging markets (China, India, Russia, Latin America, etc.), from a recent posting of mine on Twitter:
The trailing-twelve-month Price/Earnings ratio in the US is in nose-bleed territory: 24—that’s 50%+ more highly valued than the rest of the world. What does this say then? It suggests very strongly that money will begin going abroad once it feels that investors have squeezed about all the relative outperformance from US stocks that they’re going to.
Trading in the Third Quarter
The only non-rebalancing trade we made to our growth investments during the quarter was to sell some (but not all) of our investments in US large cap growth stocks (ticker: SCHG) and US small cap stocks (ticker: SCHA). When things do well, as these two investments have, we pare back their exposure within the portfolio to reduce risk—often the higher you fly, the farther you fall.
With that added cash, we increased our exposure to the worst performing part of the capital markets of late: emerging markets stocks (ticker: SCHE). To understand why, first take a look at the divergence of emerging markets to the US that began when the tariffs started to hit the news in May.
But it’s not just against the US where emerging markets have lagged. This is a chart of the relative valuation between emerging markets stock and their developed market counterparts globally:
Emerging markets have lagged demonstrably, and are very cheap compared to the rest of the world. And again, why? Trade. Recall last quarter’s Review where I showed the economic dependence on trade by country—the emerging markets are the most trade-dependent (measured as trade as a percentage of GDP). So how does that get rectified? Trade renegotiation with the US. We just saw Canada and Mexico come back to the table to concede to President Trump’s rewriting of NAFTA. One by one, most other countries that are currently struggling under trade tariffs will do the same, and that will allow their markets to rebound.
Foreign markets will lead the US, and emerging market will lead the world, in the next 5-10 years. And just lately, it finally looks like others are trying to get in line to take advantage: