I spent a lot of time during 2014 talking about the tragedy of de-diversification among investors.
Market participants were asking the question daily: “Why own anything other than the S&P 500?” You heard it in the media and at the dinner table. It was the de rigeur posturing of the market punditocracy and the subject line of a thousand emailed queries from investor to advisor.
You don’t hear much of that right now.
The S&P 500 is up less than 3% thus far in 2015 and is essentially flat since Thanksgiving. Meanwhile, the MSCI Japan is up 13% and Emerging Markets are up 8% so far in 2015 – and that’s after adjusting for the US dollar. Many European markets are up double-digits for the year with new all-time record highs in the German Dax as well as London’s FTSE 250, which is up 11% and is not denominated in the euro currency.
The real money is being made outside of US large cap stocks in 2015 – a sort of reversed mirror-image from the environment investors had grown accustomed during the majority of the post-crisis period.
We wrote several letters to clients last year explaining and then reiterating our reasons for maintaining global diversification, despite its recent unpopularity. We conducted entire conference calls devoted to the principle and spent countless hours in one-on-one conversation on the same topic. And I put up a fair amount of blog posts about this as well. (see When Diversification Feels Like %$#@ and Thowing in the Towel on International Stocks as two of dozens of examples).
Jeffrey Gundlach once told an audience at a New York City luncheon that “Whenever you hear people in the investment business say ‘Never’, that means it’s about to happen.” He was referring to Treasury bond yields going lower but this statement could be every bit as applicable when looking at the possibility of international stocks outperforming US stocks. “Never.” There was no reason to expect it to happen.
Except it did – it is happening now.
The Impossible Trade in 2013-2014 was eschewing some US equity exposure for Europe and Asia stocks, despite the fact that two of the biggest catalysts imaginable – Euro QE and the Shanghai-Hong Kong “through-train” – were both clearly imminent. Even with these deus ex machina events being on the horizon throughout 2014, the idea that foreign markets should be bought aggressively was anathema to those who extrapolate recent conditions into permanent ones in their own minds. Allocating in the rear-view mirror is probably one of the top mistakes that investors make in every era. As my friend James Osborne likes to remind investors, what happens over most years doesn’t necessarily happen during every year.
Eric Peters describes reality as an unnamed industry contact of his sees it, circa today, in his most recent Weekend Notes letter:
“Went to a CIO dinner in early October,” said the CIO, one of the market’s top performers. “Not one guy was willing to buy Europe or Japan – they all wanted to own the S&P.” German stocks are up 32% since Oct 1st. Japan +24%. S&P 500 is +8%. And Shanghai quietly surged +70%. “China is the most interesting; a year ago stocks traded 8.5x earnings, now they’re 12x and headed to 16x, maybe 20x.” And tempting as it is to call that kind of parabolic move a top, name one person you know who is limit long.
“The reason China goes ape in the next few months is simple,” continued the same CIO. “It is one of the few markets in the world that is completely uncorrelated to the dollar.” When building a portfolio today, it’s nearly impossible to find assets that don’t rise and fall based on the movements of America’s currency. Stocks, bonds, commodities, oil. And every FX pair on the planet. “That’s why so much money will flow to China – people need uncorrelated trades and there are so few of them.”
Maybe non-correlation is the reason for China’s most recent surge or maybe it’s the historic linking of Hong Kong with the stock exchanges on the mainland. It could also be recent noises out of the PBoC about stimulus. Or it could simply be the natural ebb and flow of geographic regions oscillating between sentiment regimes of neglect and adoration. The proximate cause doesn’t matter, and can only be assigned to a rally like this ex post facto anyway.
The point is not that we can (or should) know the Why behind a market move in advance. Rather, we should know of the possibilities, the probabilities, that such a thing can take place. I know of no one who can consistently time the starting points of a major market coming in and out of favor among investors. Thankfully, none of us have to invest based on anyone being able to do this.
Owning Europe, Japan and the Far East was an Impossible Trade for US-centric investors thanks to the negative commentary surrounding these regions’ economic prospects, political challenges and demographic realities. Investors had every reason to dump them from their portfolios as the S&P 500 raced higher, almost all by itself, while global PMIs slumped across the board.
But the word “Impossible” has no place in the vocabulary of an experienced investor.
And the word “Never” should set off a pavlovian response in our minds that it is time to think hard about the non-consensus possibilities inherent in financial markets.