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For what has felt like an eternity, the S&P 500 has dominated its counterparts—developed foreign (EAFE) and emerging markets (EM). While there have been brief periods over the past decade when the S&P 500 lagged, those moments have been few and far between.
Given this outperformance, many investors wonder whether just investing in the S&P 500 is enough and if diversification is “broken.” While the outperformance cannot be denied, history paints a different picture, and ignoring it could be a mistake.
U.S. OUTPERFORMANCE
Since the start of 2012, the S&P 500 has been at or near the top in returns each year! This type of extended outperformance can make you think twice about adding to other asset classes as they have lagged for a considerable period.
But if we look at the bigger picture, things look very different from 2006 to 2009. Let’s take a closer look at the total returns during this period:
Emerging markets (EM): +98.2%
Developed ex-U.S. (EAFE): +27.9%
S&P 500: +10.8%
I can assure you many were questioning the logic of owning the S&P 500 as it lagged for nearly four straight years! Emerging markets outperformed the S&P 500 by a whopping average of 21.85% a year during this period.
The truth is markets operate in cycles. There are and will continue to be periods where one asset class outperforms most others. Now, unless you know which and for exactly how long, owning a portion of all is likely your best bet. Deciding on which markets and at what percentage is a separate discussion in and of itself.
One thing that often gets lost in the shuffle is the importance of rebalancing. This involves selling profits from your best-performing assets and buying more of your underperforming ones. Repeating this process leads to not only lower volatility but also higher total returns!
The question of why the S&P 500 has been dominant for most of the past decade boils down to two main factors, in my opinion: the Federal Reserve and the rise of Big Tech.
FEDERAL RESERVE
To be clear, the entire global economy has benefited from lower interest rates, but only the U.S. could borrow as much and be as accommodating. Given that the U.S. dollar is the world’s reserve currency, the Fed can leverage this to its advantage, which helped coin the phrase “Don’t Fight the Fed.”
Now, this can be a two-way street, as we have experienced this year! But it was pretty much a one-way street for most of the past decade as the Federal Reserve and U.S. corporations took full advantage of the situation.
As the chart below illustrates, stock buybacks and dividends have been rising since 2011, excluding the initial drop at the onset of the pandemic. This rise coincides with the S&P 500’s extended period of outperformance. Is this the only reason? No, of course not, but it is a major one.
Corporations took advantage of the Fed’s policy of record-low rates and willingness to step in and assist markets at nearly every turn. With inflation still near 40-year highs, the Federal Reserve currently has its hands tied, which partially explains why markets have struggled this year.
BIG TECH
The scale at which a handful of tech companies have grown over the past decade seems near impossible! In mid-2021, Apple, Microsoft, Amazon, and Google each reached market capitalizations well above $1.5 trillion! To put this in perspective, here are the market capitalizations of a few countries:
Italy: $2 trillion
Brazil: $1.8 trillion
Spain: $1.4 trillion
Mexico: $1.3 trillion
In 2021, Apple reached a market capitalization of $2.2 trillion, which would have made it the eighth-richest country in the world!
The common denominator among these stocks? They are U.S. companies listed on the S&P 500! These five alone play a large role in the S&P 500’s outperformance. The irony is all these stocks, minus Apple, are down over 20% this year! While they will likely remain big players for the foreseeable future, that doesn’t mean their stocks will.
GLOBAL VALUATIONS
While the U.S. economy is in better shape than most, the question is: how “expensive” is it relative to others? With investing, valuations matter since you are paying a price for ownership. I believe the U.S. economy will remain one of the strongest, but that does not mean it will continue to outperform, given its lofty valuations compared with the rest of the globe.
The U.S. still has significant leverage as it is more developed than most. And while innovation and other opportunities will arise, many countries are in the early stages of economic expansion and tapping into capital markets. With these factors come additional challenges, but also more room for growth and opportunity.
In addition, many of these markets are trading near their cheapest levels in over a decade compared with U.S. markets. While the dollar is likely to remain the world’s reserve currency, it is at its highest level since 2002 due to the U.S. recovery and the Fed raising rates. If the recovery lessens or the Fed slows the pace of rate hikes, the dollar could lose steam, which would be bullish for foreign currencies and their markets.
Investing abroad does present geopolitical, currency, and regulatory risks. But it also offers a vast opportunity to tap into markets with monumental growth potential as the global economy expands. Higher volatility should be expected, and because of this, we value some level of active management in foreign markets, as there is a lot to navigate through!
Discuss your situation with a fee-only financial advisor.