10 Years Hence

10 Years Hence

Published On: February 8, 2018

Written by: Ben Atwater and Matt Malick

About ten years ago, we saw two things in the marketplace for investment advice that we believed presented an opportunity.

For one, we thought consumers without many millions to invest were getting cookie cutter products or, at worst, dishonest products and poor service to go along with it.

We also felt strongly that investment managers were over-diversified and buying things like international, emerging markets, commodities, managed futures and hedge funds in the name of diversification, but were really chasing performance (and higher management fees).

We decided to go a different route and offer people tailored portfolios using mainly individual securities that were, broadly speaking, more U.S. focused.  Indeed, we hit this big theme right.  It wasn’t perfect by any means.  For example, we have a value orientation in a time when growth is better.  But, by and large, our U.S. and individual securities call was correct.

Today, we are writing you as we make a pivot.  Not a wholesale change, but a small adjustment, which may grow to a larger adjustment over the next few years.

Price matters.  What you pay for an investment, over the longer-term, say ten years, is of vital importance.  U.S. stocks are now, given their substantial outperformance during this bull market, expensive.

Looking longer term, over the next ten years, we believe the next major equity bull market is more likely to occur in emerging market stocks than in domestic equities.  Although not cheap, they offer a significant discount to U.S. stocks.

Emerging market stocks are from countries that are in an emerging growth phase and offer higher potential returns, with higher risk (more volatility), than developed countries.  The largest weightings in the emerging markets index are China, South Korea, Taiwan, India, Brazil and South Africa.  Many of these emerging market countries are experiencing significant growth from middle class consumers who are driving increased demand.  Furthermore, many of these nations are beginning to trade more extensively with one another as they negotiate trade pacts between their respective countries.

A few numbers tell a big story.  The price-to-earnings (P/E) ratio for emerging markets is 17.01, whereas the price-to-earnings ratio on the Standard and Poor’s 500 is 23.55.  Assuming that the emerging markets P/E stays the same and the S&P reverts to a far more normal 17, where emerging markets currently stand, this reversion to the mean would imply a 3.2% per year headwind over 10 years or a 6.3% per year headwind over 5 years for the S&P 500.

Over the ten years ended on December 31, 2017, the S&P has returned 8.45% per year, whereas emerging markets have returned 1.30% per year.  Again, we see a reversion to the mean occurring over the next decade.  Last year, emerging markets may have begun the turnaround with a 36.42% return versus 21.75% for the S&P 500.

A weak U.S. dollar adds to your returns when investing in overseas stocks. If the dollar falls 3%, you get a 3% boost to your international stock returns.  Over the last ten years, the AMEX Dollar Index has gained 18.7%, but over the last year the index has lost 10.2%.  We think the odds are good that the dollar will remain weak, reverting to its mean, and adding to returns over the next cycle.

Because of the inherent volatility of individual emerging market stocks and currencies, it’s not sensible to buy the common stock of individual companies.  Furthermore, emerging market countries don’t always have the same legal standards for transparency and financial reporting that developed countries require.  As fiduciaries, managers mandated to work in your best interest, we believe that offering you emerging market exposure is the correct long-term decision, which leaves the question of how best to accomplish this pivot.

We are utilizing EEM, which is the iShares MSCI Emerging Markets ETF.  An ETF trades like a stock with its pricing continuous throughout the day.  EEM is meant to track the investment results of the MSCI Emerging Markets Index, composed of large and mid-capitalization emerging market equities.  The fund has exposure to over 800 companies.  While we’ve often advised against over-diversification, our concerns about the single-stock risk in emerging markets outweighs our preference for individual stocks.

In most cases, we are not adding to our clients’ net equity exposure.  We are still skeptical of today’s stock market, even emerging markets in the near-term.

Recent market moves are a small example of the kind of volatility and risk that should be expected following an extended period of minimal volatility and consistent gains.  As we said to you in our note, Who We Are, last week, “we caution against excessive enthusiasm.  We urge you to consider the contrarian view and to make an honest assessment of your risk tolerance.”  We will continue in our efforts to balance risk and return and to help clients think long-term about opportunities.  In the meantime, if you find yourself concerned about the market’s current declines, please call us so that we may address your specific questions and circumstances.


Please visit www.atwatermalick.com/ria for full disclosure materials related to recommendations contained in this update.

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