Rethink Your U.S. Exposure: Foreign Markets To Outperform? | Cullen Roche

Key Concepts

• CAPE Ratio (Cyclically Adjusted Price-to-Earnings Ratio): A valuation measure that uses average inflation-adjusted earnings over the past 10 years to assess whether the market is overvalued or undervalued.
• Mag Seven: Refers to the seven largest US technology companies (likely Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta) that have driven a significant portion of market returns.
• Global Financial Asset Portfolio: A theoretical portfolio representing the true market capitalization of all investable financial assets globally, differing from standard market-cap weighted indices due to investability constraints.
• Debasement Trade: A strategy based on the expectation that a currency will decline in value, making foreign assets more attractive.
• Mean Reversion: The idea that asset prices and historical returns will eventually revert to their long-term average or mean.

Divergence in Market Valuations & The Case for Global Diversification

The speaker highlights a significant divergence in CAPE ratios between the US market (currently at 40) and foreign markets (mid-20s), a disparity unprecedented in history. This divergence forms the core argument for increased global diversification. The speaker believes that emerging and developed international markets could outperform the US by a factor of 5 to 10 over the next 5-10 years. Last year already saw foreign markets nearly double the returns of US markets, with minimal change in CAPE ratios, suggesting the trend is already underway.

Identifying Key Risks & Portfolio Allocation

The primary risk currently isn’t macroeconomic, specifically not a debt-driven deflationary crisis. Instead, the speaker expresses concern over US equity market valuations, particularly given the current administration’s “anti-dollar view.” This concern is compounded by the concentration risk within the US market, specifically the dominance of the “Mag Seven” technology companies.

The speaker advocates for a more cautious approach to US equities, suggesting a more diversified domestic portfolio tilting towards value and quality stocks – those that have underperformed recently but may offer better future returns. This diversification aims to reduce concentration risk and insulate against potential acute risks.

The Currency Story & The Double Hedge

A central argument is that international diversification isn’t primarily about betting on foreign companies outperforming US corporations. Instead, it’s a “currency story” – a bet that the US dollar will weaken. This weakening dollar would increase the value of foreign stocks when measured in US dollars, creating a “foreign exchange trade.”

This approach functions as a “double hedge”: it mitigates the concentration risk of the “Mag Seven” and acts as a domestic inflation hedge by benefiting from a potentially declining dollar. The speaker believes we may be in the early stages of this reversal, with last year potentially being the first of many years of international outperformance. As stated, “diversifying to international stocks is not so much a bet on foreign companies outperforming or or out competing US corporations. It's a currency story really that you're really betting on that the dollar will be weak.”

The Illusion of Diversification in Passive Investing

The speaker delves into the complexities of passive investing and the limitations of market-cap weighted indices. They introduce the concept of the “Global Financial Asset Portfolio” – a theoretical benchmark representing the true market capitalization of all financial assets globally.

They explain that standard indices like Vanguard Total World are constrained by investability. For example, significant portions of the Chinese stock market are inaccessible to foreign investors. This forces index providers to overweight the US market and, consequently, the technology sector, creating an illusion of diversification.

Currently, the investable market is approximately 65% US and 35% foreign, while the actual issuance of financial assets is closer to 35% US and 65% foreign. This means investors buying market-cap weighted indices are unknowingly more heavily exposed to the US and technology than they realize. As the speaker notes, “everybody deviates from the global market capitalization of all financial assets in the world… everybody’s active.”

Historical Context & Mean Reversion Expectations

The speaker emphasizes the historical divergence in CAPE ratios, stating, “we’ve never seen a divergence like this. The ratio has never been this divergent in its history.” They acknowledge they aren’t necessarily bearish on the US, but anticipate a degree of “mean reversion” in CAPE ratios over the next 10 years. They believe it’s highly probable that the current divergence will eventually correct itself, at least partially.

Data & Statistics

• US CAPE Ratio: 40
• Foreign Markets CAPE Ratio: Mid-20s
• Last Year’s Performance: Foreign markets nearly doubled the returns of US markets.
• Global Financial Asset Portfolio: Approximately 35% US / 65% Foreign (based on issuance), versus 65% US / 35% Foreign (based on investability).

Conclusion

The speaker presents a compelling case for increased global diversification, driven by historically high US valuations, concentration risk in the “Mag Seven,” and the potential for a weakening US dollar. They argue that international diversification isn’t simply about finding better companies, but about strategically positioning a portfolio to benefit from currency movements. The speaker also cautions against the illusion of diversification offered by standard market-cap weighted indices, highlighting the importance of understanding the underlying composition of these portfolios. The overall takeaway is a call for a more cautious and diversified approach to portfolio allocation, recognizing the potential for a significant shift in market leadership over the next decade.