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The gains can’t go on forever, BUT… Look East Young Man

Global stock markets just broke a big record…

So far this year, the MSCI All Country World Index (which reflects the performance global stock markets) has posted a gain every single month. That’s an unpreceded streak of monthly gains for the 22-year old index.

And at this point, the index is likely to post a gain every single month for the whole year (November and December are typically bullish for stock markets). Again, this would be the first time this has ever happened in the 22-year history of the MSCI All Country World Index.

That sounds like good news. What’s not to like about rising stock markets?

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But sooner or later, the good times have to end…

And for the U.S. stock market (which makes up 52 percent of the MSCI All Country World Index), the end is coming closer.

The gains can’t go on forever

The table below shows the years that have had the most consecutive monthly gains in the history of the MSCI All Country World Index.

After a rocky start to the year, 2003 had nine consecutive months of gains. Three years later, in 2006, there were six. And 2004, 2005 and 2014 all had five consecutive months of gains.

Of course, nothing goes up forever. After a nine-month run in 2003, the index continued to move higher in January and February of 2004, before falling the next two months. A few years later, following  a six-month streak in 2006, the index continued higher in January 2007 before correcting 0.7 percent in February.. And after its five-month streak in 1993, the index corrected 1.2 percent in month 6.

Mean reversion, as I’ve talked about before, means that markets (along with most things in life) tend over time to reverse extreme movements – and gravitate back to average.

It’s like a rubber band… stretch it and when you let go it returns to its original shape. So after a period of rising prices, securities tend to deliver average or poor returns. Likewise, market prices that decline too far, too fast, tend to rebound. That’s mean reversion, and it works over short and long periods.

Right now, markets around the world are “stretched” and could snap back to their “original shape” at any moment.

The S&P 500 is at an extreme. It’s up 461 percent from its lowest point in March 2009 (in U.S. dollar terms, including dividend reinvestment). That’s compared with 367 percent for MSCI Asia ex Japan, 359 percent for Singapore stocks and 356 percent for Hong Kong’s Hang Seng over the same period, as the graph below shows.

We’ve seen this sort of outperformance before. In the late ‘80s and early ‘90s, U.S. stocks outperformed other global markets by 100 percent. But eventually, U.S. stocks came back to earth… and over the following years, global (ex U.S.) stocks outperformed U.S. stocks by 39 percent.

The same thing happened again in the late ‘90s. U.S. stocks outperformed by 215 percent, but then global (ex-U.S.) stocks ended up outperforming U.S. stocks by 88 percent in the following years.

 

So eventually, U.S. stocks will come back down to earth – taking the MSCI All Country World index with it.

But mean reversion isn’t the only reason we think the U.S. bull market is winding down…

Overpriced equities

Right now, by many measures, U.S. stock market valuations are high.

One of the best ways of measuring market value is to use the cyclically-adjusted price to earnings (CAPE) ratio. It’s a longer-term inflation-adjusted measure that smooths out short-term volatilities to give a more comprehensive measure of market value.

As the chart below shows, the CAPE is now at 27.3 times earnings. That’s higher than any time in history, except for the late ‘90s dotcom bubble. It’s even higher than the stock market bubble of the late 1920s.

High valuations don’t mean that share prices will fall. High valuation levels can always go higher, at least for a bit. Or they could stand still for a while. But mean reversion suggests that at some point, valuations will fall, one way or the other. (Unless “this time is different”. But… it isn’t.)

So what should you do?

Look to diversify your portfolio a little. Regular readers will know that we’re big fans of diversification.

We’ve written before about the importance of not just investing in different sectors and asset classes… but in different markets and countries too. That’s because spreading a portfolio around the world reduces risk. After all, gains in one market can offset losses in another.

And while the gains in U.S. stocks are nearing an end, they’re just getting started in markets like India, Bangladesh and Vietnam. These are three of the fastest-growing markets in the world.

So do yourself a favour and consider moving some of your money elsewhere.

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