If history has taught us anything, it is that markets are cyclical. They rise and they fall, and just when investors convince themselves that the pattern has changed, it continues.

Of course, there is always going to be uncertainty about the markets in the short run. The volatility of investor sentiment reflects this fact very well. As 2018 has progressed, investors feeling bullish and neutral were largely split, with less currently feeling bearish.1 Only time will tell whether the bullish sentiment will continue as the year progresses.

Source: American Association of Individual Investors (AAII) Sentiment Survey, As of May 30, 2018.

1 American Association of Individual Investors (AAII) Sentiment Survey. As of May 30, 2018.

Investors should look past the flawed notion that today’s environment is somehow unique.

Such a shift is often driven by a short-term focus, something experienced investors understand can be dangerous. It is more important to place what is happening right now within the greater context of history. Doing so can give investors a distinct advantage. Not only can they look past the near term and avoid the flawed notion that today’s environment is somehow unique, they can use the cyclical nature of the markets to seek consistent success within their investment portfolios.

With that in mind, today investors face a critical question: how should I be allocating to equities? Defining an appropriate approach can be supported by recognizing three factors.

Global Equity Valuations Have Diverged

U.S. stocks remain in the midst of a long-term bull market. Since the bottom of the market during the global financial crisis, the S&P 500 Total Return Index has returned 476% cumulatively (March 9, 2009 through December 31, 2017). Furthermore, the recent market environment has been marked by low levels of market volatility and relatively few severe pullbacks. After nearly 10 years, it is quite possible that investors have lost sight of two important things.

First, volatility can certainly increase. It only requires a look back to the prior cycle to provide a reminder that investor sentiment can change quickly and lead to higher volatility.

Though volatility has been persistently low in the past year, investors have experienced much rockier markets within the past decade

Source: FactSet, Chicago Board Options Exchange (CBOE). As of December 31, 2017.
Past performance is no guarantee of future results.

Second, and possibly more important, the U.S. equity market valuations have become noticeably elevated relative to both international equities and the norms of the past.

Recent years have seen U.S. valuations increase far more rapidly than international valuations

Source: Bloomberg, Robert Shiller, Yale. S&P 500 Index and MSCI EAFE as of December 31, 2017. MSCI EM as of May 31, 2017.

In fact, the cyclically adjusted price-to-earnings ratio (CAPE)1 for U.S. equities is at a record high relative to its past history—in the 100th percentile2—while price-to-book (P/B) ratios are in the 96th percentile3 of historical values. Conversely, international valuations remain low. Price-to-earnings (P/E) ratios on the MSCI EAFE (representing developed countries outside of the U.S.) and MSCI Emerging Markets indices are approximately 40-60% lower than their U.S. counterparts.

High valuations mean higher risk to U.S.-heavy portfolios if or when markets change direction, while lower valuations may mean buying opportunities in international markets.

1 Cyclically adjusted price-to-earnings ratio (CAPE) is a valuation measure that is defined as price divided by the average of ten years of earnings, adjusted for inflation.
2 Shiller and CAPE data for S&P 500 Index from 12/31/04—12/31/17.
3 P/B data is from 02/28/01—12/31/17.

Performance of Global Equities Has Been Cyclical

Valuations are only one of the reasons for investors to reconsider their current allocations to U.S. and international equities. The truism of cyclicality is another. Over time, U.S. and international equities have tended to alternate their periods of outperformance. Since 1975, the average cycle of outperformance for either U.S. or international equities sits at approximately 6.9 years, which just so happens to be approximately how long domestic stocks have outperformed in the current cycle based on the difference in rolling 5-year returns.

Returns over the past 40+ years demonstrate the cyclical nature of U.S. and international equity performance

Source: MSCI, Standard and Poor’s, FactSet as of March 31, 2018. The chart displays the difference in rolling 5-year annualized performance of the S&P 500 Index and MSCI World x USA. Past performance is no guarantee of future results.

For the first time since 2009, International markets outperformed U.S. markets in 2017. History suggests that this may indicate the start of a cyclical trend.

Current Allocations May Be Skewed

The ongoing bull market in the U.S. is notable for both its duration and its magnitude. It has simply been an excellent decade for U.S. equity markets.

While this has been a boon for many investors, it has also created the potential for unwanted risk. Specifically, investors who have not periodically rebalanced their portfolios may find themselves over-allocated to U.S. equities and under-allocated internationally.

Such a situation not only deviates from many investors’ ideal allocation, but also exposes them to greater downside if (or when) the current bull run ends.

Dynamic International Equity Markets Review

The track record of International, Emerging Markets, and International Small Cap equities may surprise you.

 Roll over for a breakdown of the Diversified Portfolio

Source: FactSet. As of December 31, 2017. Click here for a list of representative indices. Past performance is no guarantee of future results.

Diversification does not guarantee a profit or protect against a loss in declining markets.
The indices are unmanaged, are not available for investment and do not incur expenses.
The performance shown is not indicative of the performance of any mutual fund or other investment product.

A Plan of Action

The combination of divergent valuations, performance cyclicality and unbalanced portfolios leads to two potential pathways for investors:

1. Enhance International Exposure:

Now may be an opportune time to allocate (or re-allocate) additional assets to international equity strategies. Taking a more global approach may benefit investors by providing:

  • Improved portfolio diversification
  • Potential upside if the relative performance of international markets improves

Funds to Consider

2. Take a More Conservative Domestic Approach:

Of course, investors still want—and require—U.S. equity exposure, but it may be wise to alter the nature of that exposure via investments that combine:

  • Strong attention to risk and allocation to investments than can potentially provide greater downside protection relative to an index
  • A conservative approach focused on undervalued stocks

Funds to Consider

Over time, the challenges facing investors change. However, many of those challenges have arisen before, and recognizing that fact can provide an advantage in navigating uncertain markets. It is the key to turning cyclical markets into consistent success.