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Emerging Concerns

Adam M. Grossman  |  November 1, 2020

AT 82 YEARS OLD, investment manager Jeremy Grantham has seen his fair share of market cycles. And as a U.K. native living in the U.S., he has the interesting perspective of an outsider. In a recent interview, Grantham shared his unvarnished view of the U.S. market. “American capitalism has become fat and happy,” he said. The U.S. stock market is in a bubble that will likely burst within “weeks or months.”

I don’t believe anything should be judged over the span of a single week. Still, the market did drop almost immediately after the interview, making Grantham appear prescient. But let’s back up a little and understand Grantham’s concerns. He cited two.

The first concern: valuations. “We’re in the highest 5% of P/Es [price-to-earnings ratios], and we’re in the lowest 5% of economic conditions.” In other words, we’re in a recession, but the stock market is inexplicably flying high. “There’s never been anything like that in history,” he added.

Grantham’s second concern: “signs of truly crazy behavior.” In his experience, high valuations alone don’t cause bubbles to burst. But when high valuations are combined with increasingly risky investor behavior, the end may be near, Grantham says. That, unfortunately, is what he is seeing now.

He cites investors piling into Tesla shares, causing them to quadruple this year, while also driving up the price of Hertz shares, despite the company being in bankruptcy. Then there’s the recent boom in special purpose acquisition companies (SPACs), otherwise known as “blank check” companies. Grantham equates SPACs to the South Sea Bubble: “Give us your money, and trust me, I’ll do something useful.” His characterization, in my view, is not unreasonable.

For both of these reasons—high valuations and risky behavior—Grantham thinks investors should get out of the U.S. stock market. While he allows for a few exceptions, ideally, Grantham says, investors should “avoid the U.S. entirely.”

Instead, he recommends investors shift to emerging markets, including China, Russia and India. They’re “growing far faster” than developed markets like the U.S. and Europe. They’re “cheap, it’s a great opportunity.”

Is this the solution? Should you abandon U.S. stocks in favor of emerging markets? While I don’t disagree with some of Grantham’s concerns about the U.S. market, I do disagree with his prescription—for three reasons:

1. If you need to pay your bills in a particular currency, it’s prudent to have your assets in that same currency. For investors in the U.S., I think you want to have most of your assets in dollars. While it’s often overlooked, currency moves can materially impact the value of an international investment.

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Consider a popular iShares index fund (ticker: EWZ) that tracks Brazil’s stock market. According to the iShares website, the fund was down more than 40% through the end of the third quarter. But Brazil’s market isn’t really down 40%. It’s down less than 20%. But because Brazil’s currency has depreciated this year, the results have been far worse for American investors. Of course, this can cut both ways. If a currency appreciates, it can boost returns. But investing is unpredictable enough without worrying about currencies too. That’s why I wouldn’t jump into emerging markets stocks with both feet.

2. Valuations on some domestic stocks are high, but not on all of them. These days, the big technology stocks—Amazon, Apple and so on—get all the attention, and they certainly carry valuations that look stretched. But within the S&P 500, there are still more than 280 stocks that are underwater for the year-to-date. It strikes me as an overreaction to say that you’d have to leave the U.S. entirely to find reasonably priced stocks. In fact, all you’d have to do is add a simple value-stock fund to your portfolio. In Vanguard’s Value ETF (ticker: VTV), for example, more than two-thirds of the holdings are down in 2020. These stocks offer demonstrable value—and they’re all domestic.

3. While the U.S. isn’t perfect, many emerging markets countries have policies that should give investors pause. Some have authoritarian regimes. Others exhibit little respect for intellectual property and have shown a willingness to confiscate or nationalize businesses. Corporate governance and accounting rules are more lax.

Should you diversify your stock portfolio outside the U.S.? Absolutely. The data definitely indicate there’s a diversification benefit. I just wouldn’t take it to the extreme that Grantham recommends. I suggest allocating 20% of a portfolio to international stocks. Others prefer more of a market-weighted approach, with something closer to 50% outside the U.S. That’s fine, too. There is no historical data that dictate a specific percentage. The best approach, in my view, is the simplest: Diversify broadly and avoid going to any one extreme.

I should note that Grantham does recommend one other investment category. “If you insist” on investing in the U.S., he recommends venture capital. This is an interesting recommendation. But as one prominent venture capital insider acknowledged, the best venture capital firms are closed to everyday investors. Because of the dispersion in quality among venture capital firms, which I described in September, you really don’t want to be invested in lower-tier funds. The upshot: While venture capital investing can work out well, unfortunately it isn’t a feasible option for most people.

Adam M. Grossman’s previous articles include Look Under the Hood, Follow the Fed and Save and Give First. Adam is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, Adam advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman.

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