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"What we find is no surprise," noted Mr. Faber in a 2012 research paper outlining the findings. What really matters is whether you buy stocks when they are cheap or when they are expensive. "It is almost a perfect stair step," he wrote. "Future returns are lower when valuations are high, and future returns are higher when valuations are low."
U.S. stocks are expensive because investors have become increasingly optimistic about the U.S. economy and the continuing boom in corporate profits. The Federal Reserve has bolstered the enthusiasm by pumping liquidity into the financial system in recent years.
Is that optimism misplaced? Maybe. But it doesn't really matter. What matters is how far that optimism is already reflected in the high price of stocks.
The world economy is increasingly global, so U.S. corporations are exposed to booms and busts overseas—and vice versa. A U.S. economic boom would be good for companies in Japan, and a slump in Asia, for example, would be bad for U.S. companies.
Three years ago, global investors were similarly optimistic about the boom in emerging markets, and sent share prices in places such as Brazil and India soaring. Since then, growth in those countries has disappointed.
Ways to Capitalize
Emerging markets have also been hit by political turmoil and in some cases by inflation. The stocks, which had been priced to reflect good news, have come tumbling down. Investors can try to capitalize on lower valuations in many overseas markets by investing in mutual funds or exchange-traded funds that invest in individual countries, such as the iShares MSCI Germany Index or iShares MSCI Japan Index ETFs. But for many investors, that strategy would be too aggressive, too complicated and too costly.
A simpler strategy is to hold more of your investments in a global portfolio of U.S. and overseas stocks and to rebalance it every quarter or every year.
Many investors are encouraged to hold perhaps 80% of their money in U.S. stocks and maybe 20% in international issues. This is the wrong way 'round. The U.S. now accounts for a little more than 20% of the global economy.
A more sensible allocation might be to invest one-third of your money in the U.S. stock market, one third in developed international markets—such as a fund that tracks the Europe, Australasia and Far East (EAFE) index—and the remaining third in the MSCI Emerging Markets index. This strategy gives you access to an array of low-cost mutual funds and exchange-traded funds that invest in each of these indexes.
To be sure, there is a "currency risk" to overseas investments. Foreign currencies may weaken against the dollar, reducing the dollar value of a U.S. investment.
Overstated Risk
But this risk is usually overstated. Foreign currencies are just as likely to strengthen as they are to weaken. And local stock prices tend, over time, to compensate for currency fluctuations, rising if the currency falls and vice versa.
Conventional wisdom says that international stocks are riskier than U.S. shares and that you should severely limit your exposure to them, especially if you have what brokers call a "low tolerance for risk." It's a mantra repeated frequently by investment managers, but repetition doesn't make it true.
Conventional wisdom works for professional money managers because it limits their legal liability if things go wrong. But a private investor acting on his or her own can do better.
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