What might one of Buffett’s favorite stock market valuation indicators tell us about a margin of safety and diversification?

The US stock market has been on a relentless tear barely registering just a couple of small double-digit declines in the last 8 years.  But where has this left us in terms of valuation on US stocks and why does it matter long term?  Well, historically we know valuations do matter in the long-term (7-12 years or more), not necessarily in the short-term (1-3 years).  Short term, markets are generally driven by the willingness of investors to take risk and thus investor psychology and market sentiment.  But long-term time and again we have historically seen markets revert to long-term growth rates as the economy cyclically experiences higher and lower profit margin cycles.

We know that during the past 5 years as the US markets soared, international developed and emerging markets generally were sideways to down.  That has left these markets in general far cheaper than their US counterparts.  Below you’ll see the resulting expected future returns net of inflation Research Affiliates* expects for the major asset classes over a 10-year period.  You’ll see, however, that exposure to international and emerging markets in their view offers greater potential returns but has more risk/volatility.  The point here is that looking further out into the future if you have enjoyed the benefits of a US-only portfolio it may be beneficial to diversify some of your holdings overseas.  Each investor needs to evaluate with their advisor through portfolio stress testing what allocation makes the most sense for them.   However, if these estimates are even in the ballpark (they corroborate many other research firms who do this type of valuation work) lower than historical returns long term for the US stock and bond markets should be expected.

This brings us to the title of this piece and why building a margin of safety is an important factor in investing.  I’ll let Jesse Felder of the Felder Report succinctly share with you why this is so critical, however, it helps makes the case for some consideration of global diversification of your portfolio.  For what it’s worth, YTD we have seen international and emerging markets outpace its US counterparts as measured by the major indexes (S&P 500, MSCI EAFE, MSCI EM).  A short window of time of course, but it’s a start and having that little extra margin of safety with lower valuations helps.  Just something to think about.

Here’s Jesse Felder:

https://www.thefelderreport.com/2017/05/25/if-there-was-ever-an-example-of-reward-free-risk-this-is-it/

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

Stock investing involves risk including loss of principal.

International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.

*Research Affiliates return forecast methodologies can be found here

MSCI performance returns are believed to be reliable but no guarantee is made to their accuracy.

Financial Planning, Investment Advisory Services and Securities offered through LPL Financial,

A Registered Investment Advisor and Member FINRA/SIPC