Overweight stock markets – Should you do it?

In the days before we had access to cheap index funds lots of investors had the odd overweight stock or two in their portfolios. Nowadays with the emergence of exchange traded funds (ETFs) investors can easily overweight entire stock markets.

What is an overweight stock?

Financial analysts use overweight alongside under and equal weight as a way to rate stocks.

Having an overweight stock in your portfolio essentially means you have more of that stock than the benchmark weight. Underweight means you have less than the benchmark, and equal weight means you follow the benchmark.

There are many different kinds of benchmarks out there but most popular stock-market indices are weighted by market capitalization.

Market capitalization is calculated by multiplying the total number of shares of a company by its share price.

For example a company with 10 million shares selling at $100 a share would have a market cap of $1 billion. Add up the companies from a particular country and you’ve got the market capitalization of that country.

So big companies take up a larger share of the stock market, and then countries with bigger companies take up a larger share of the world market.

Let’s say your benchmark is the FTSE 100 index and HSBC makes up 10%. Usually, you’d invest 10% of your money in HSBC. Any more than 10% and you are overweight that stock.

So if you invested 15% of your money in HSBC, you’d be overweight 5%.

In exactly the same way that you can overweight individual stocks, you can also overweight sectors and countries.

If Technology stocks make up 5% of the index you are following, but you have 20% of your investments in tech, you are overweight tech 15%.

What does overweight stock market mean?

And of course there’s no reason why you can’t overweight stock markets themselves.

If the UK makes up 6% of the global index you are following, but you have 25% of your investments in it (lots of people do) then you are overweight the UK.

In fact, right now this is a hot topic. There’s a big school of thought out there that says you should underweight the US stock market because it is overvalued.

Perhaps the most straight forward way to underweight the US would be to invest in a US fund along side a global ex-US fund, rather than a total global index.

That way you can determine how much of your portfolio is allocated to US stocks. Typically, global portfolio’s allocate over 50% to the US.

If you invested 45% for example you’d be underweight US stocks. And when you do that you are automatically overweighting the rest of the world.

How much you overweight or underweight can represent the strength of your conviction in a particular market.

And if we were underweight the US stock market 25% we could simply increase our exposure to the rest of the world by the same amount to fill the void.

Alternatively, we could overweight a particular market that we think is likely to do well in the future.

Emerging markets

In fact, right now there are experts advocating overweighting emerging markets (EM) for example.

On the face of it, that makes sense because that’s where all the economic growth is. In fact, it couldn’t be more simple, the US should be an underweight stock market and EM should be an overweight stock market. If only it were that simple!

Remember, being underweight or overweight stock markets is essentially betting against the multi trillion dollar investment industry.

Anything other than going with a market capitalization weighted index is a big call.

Whenever you buy or sell assets on the stock market, in all likelihood the seller is a professional. 95% of trades are carried out by institutions.

Do you really know something all those financial professionals from the best business schools, with the best resources, and the most experience don’t? In most cases the answer is going to be no.

Let’s face it, if emerging markets were such a bargain all the hedge funds would be buying them!

When you hear people saying you should underweight US stocks and overweight emerging markets their arguments always sound convincing, but there are always two sides to every argument.

You get what you pay for

In reality US stock valuation may look high to some investors, but in all probability they are high because the companies have lots of cash, great balance sheets and great prospects. In other words they are stocks of great companies.

The same just can’t be said for many others countries’ companies right now.

Over the last couple of decades the undisputed champion of EM has been China, with its unbelievable growth.

Just because China’s GDP is growing fast doesn’t mean all the other emerging markets are developing fast too.

In fact just because a country’s GDP is increasing fast doesn’t mean their stock markets are going to go up at all.

Jeremy Siegel

In his investing classic, Stocks for the Long Run, Jeremy J. Siegel looks at the investment returns from emerging market countries between 1988 and 2012. That was a period when China’s economy was growing at rocket speed. It had the largest real per capita GDP growth out of all emerging market countries.

Over the period China grew a whopping 9% per year. I’m sure lots of investors will be cursing themselves for missing out on that.

But, they shouldn’t. In fact, they should let out a sigh of relief. That’s because, unfortunately for investors in the Chinese stock market, over the same period as that dramatic growth, the stock market of the very same country lost over 5% per year! There can’t have been many better opportunities to destroy a pension.

And if you think that was the exception, contrast it with the situation in Mexico, where GDP growth was just over 1% a year during the same period, yet stock market returns were about 17% annually!

Siegel says:

It will probably surprise readers to learn that there is a negative correlation between economic growth and stock returns, and this finding extends not only to those countries in the developed world but also to those in the developing world.

Jeremy J. Siegel

Fundsmith

Fundsmith Global Equity is one of the most popular actively managed funds in the UK right now. And rightly so, because it has consistently outperformed it’s Benchmark for an extended period of time.

Listen to any of Fundsmith’s Annual Shareholder Meetings and you’ll hear esteemed fund manager Terry Smith saying US companies are just better than the companies of other countries.

Lots of people who think the US market is overpriced are basing their judgement on the Cyclically Adjusted Price to Earnings (CAPE) ratio.

Sometimes called the Shiller PE, since it was devised by Nobel Laureate economist, Robert Shiller, the CAPE ratio divides a stock price by a ten year average of corporate earnings adjusted for inflation.

Shiller thinks a CAPE ratio level significantly higher than the median, indicates an increased likelihood of poor performance in the years ahead. Basically there is a reversion to the mean. Markets that outperform over one period will under perform during the next. Everything averages out over time.

The chart below compares the current CAPE ratio, with the historic median average using data from Research Affiliates.

CAPE ratio

So whereas other markets are looking cheap, the CAPE ratio certainly suggests the US is expensive, and that could have an impact on future returns. It’s not hard to see why some think you should underweight the US stock market and overweight stock markets outside the US.

But plenty of others don’t agree. Most noticeably Shiller’s long term good friend Jeremy Siegel.

Siegel uses the more common price earnings (P/E) ratio to make valuations, rather than Shiller’s CAPE ratio. The P/E ratio values a company by measuring its share price as compared to its per-share earnings.

And Siegel questions the CAPE ratio idea that there must be a reversion to the mean. He says:

Should we go back to 15 as the long-run normal (P/E ratio), or CAPE at 16.5 [median return] or so? My feeling is, ‘no, we shouldn’t.’ I say that the warranted P/E ratio is higher than history. And one of the reasons for that is indexing at zero cost, which was totally unavailable during the greatest part of this [market] sample.

Jeremy J. Siegel

Fees

Siegel’s argument is that people will be willing to pay a bit more for stocks than in the past because they don’t have to pay high fees anymore. In other words, they’ll get the same returns anyway.

Let me explain. The P/E ratio gives you an indication of what return you are going to get by simply dividing 1 by the P/E number. So if we go back to our average P/E ratio for US stocks of 15, we can see that this indicates a real return of 6.7% (1/15 = 6.7), which has more or less been the historic real return for US stocks.

But during that time investors have had to pay high fees in the region of 1.7% a year, so they were really only getting around a 5% return. In other words, investors bought stocks to achieve a 5% real return.

Index funds means these costs have been reduced to insignificance. Thus, we can just about get the same 5% via a P/E of 20 (1/20 = 5). Incidentally, at the time of writing (when everyone is saying US stocks are overpriced) the P/E ratio for US stocks (S&P 500) is 20. Maybe they aren’t all that expensive after all!

Siegel also mentions some other reasons why valuations could be justifiably higher right now.

He points to the fact that US companies are reducing the amount of dividends they pay, which should increase earnings growth and distort the CAPE ratio, and finally he points out that you’d expect a higher valuation in a low interest rate environment. And boy are we in a low interest rate environment!

Warren Buffet & interest rates

Warren Buffet echoed this sentiment in an interview with CNBC on the 25th Feb 2019 when he said:

If 30 year bonds remain at 3% for the next 30 years then stocks are incredibly cheap. Interest rates govern everything. It doesn’t look like interest rates are going to be jacked up anytime soon. We maybe in a new world. A world Japan entered back in 1990.

Warren Buffett

He went on to say that if he had a choice between buying 10 year bonds (that were paying about 2.7% at the time) or buying and holding the S&P500 (US stocks) for 10 years, he’d buy the S&P in a heartbeat, and that’s at a time when the CAPE and P/E ratios were pretty much the same as they are today.

Vanguard

I can’t leave the pro US stocks section without mentioning Vanguard.

In their study, The Role of Home Bias in Global Asset Allocation, they looked at how investors overweight their own countries’ stock market in the US, UK, Australia and Canada. They basically concluded that only US investors had any justification for overweighting their home market.

Should you overweight a stock market?

So does that mean we should overweight the entire US stock market in our portfolios? Not quite!

The bottom line is there are strong arguments for being underweight and overweight stock markets.

But, to be underweight or overweight stock markets is a big call. You are essentially betting against all the professionals that make up the wider market.

If you are really confident one stock market is going to outperform another then go ahead.

But most investors aren’t in any position to know that, so nine times out of ten it’s going to be better to go with the benchmark.

Remember, if you absolutely have to underweight or overweight stock markets, you don’t have to go all in.

Adjusting the weighting by just a couple of percent will still give you the satisfaction of outperformance if you are right, without risking too much money if you are wrong.