1) INTRODUCTION:
François Doyon La Rochelle:
You’re listening to Capital Topics, episode #78!
This is a monthly podcast about passive asset management and financial and tax planning ideas for the long-term investor.
Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio managers with PWL Capital.
In our podcast today we discuss if it is time to change your allocation to U.S. stocks.
Enjoy!
2) IS IT TIME TO CHANGE YOUR ALLOCATION TO U.S. STOCKS:
François Doyon La Rochelle:
On our last Podcast, we reviewed the performances of asset classes for the first half of 2025. Today, we are going to discuss a question we are receiving from our clients: Should we reduce our allocation to US Stocks? As our regular Listeners know, U.S. stock markets have significantly outperformed international stocks (both Developed and Emerging) since the global financial crisis of 2008-09.
James Parkyn:
François, this is indeed a question we receive frequently. So far in 2025, International stocks have outperformed US stocks. The question for many investors around the world is: How much of their portfolio should be international?
In the WSJ recently, an article by Randall Smith quoted Gargi Chaudhuri, a portfolio strategist at BlackRock, one of the largest Global Institutional Managers, “Clients have been asking us how they should rethink their non-U.S. portfolios,” she says. “A lot of people have not thought about this in the past few years.” We, of course, have addressed this issue on many of our podcasts, including #75 when we covered the UBS Global Investment Returns Yearbook 2025.
François Doyon La Rochelle:
Well, now that the U.S. stocks have underperformed, everyone is wondering if this is the turning point. And, with chaos out of Washington, we instinctively think the U.S. is not headed in the right direction.
James Parkyn:
Investors, as we have discussed many times on our Podcast, are vulnerable to hindsight bias. This has been extensively studied in Behavioural Economics. So, it is fair to say that many Investors would have a big bias towards a high allocation to U.S. Stocks, given the extended outperformance of U.S. stocks has been staggering. According to Morningstar Direct for 15 years between 2010 and 2024, U.S. stocks returned about 13.5% annually, compared with 4.8% for international stocks, based on the largest total-market index funds in each category. This is why we always look to the very long-term data to get a better picture of how to allocate funds to stocks.
François Doyon La Rochelle:
James, I recommend that our Listeners consult our Market Statistics page to get the long-term performance comparison in CAD dollars. We will provide the link to it on our Podcast page. YTD, the numbers reflect the fact that the CAD dollar gained 5.6% vs the USD. In the first six months of this year, developed international equities, measured by the MSCI EAFE, are up a strong 13.2% in CAD dollars year-to-date. In local currencies, it is up 7.8%. Emerging markets also had a good first half; large and mid-cap stocks generated 9.5% again in CAD dollars.
James Parkyn:
This international Stock outperformance is very recent and short-lived. As we discussed in our podcast # 75 earlier this year, in the last 15 years or so, U.S. Equity market returns dominated other Equity Markets. This has led many investors to question the benefits of being globally diversified. But this year, we finally see the benefit. Market History teaches us that we have to accept that sometimes diversification does not pay off.
François Doyon La Rochelle:
James, I think we need to look at why U.S. stocks outperformed over the last 15 years so our Listeners can better understand why U.S. stocks have dominated.
James Parkyn:
The WSJ article goes on to highlight the obvious, the big 15-year performance gap include a rise in the value of the dollar against foreign currencies and the U.S. dominance in high-growth areas such as tech, including the “Magnificent Seven” stocks such as Google parent Alphabet, Amazon, Apple, Facebook parent Meta Platforms, Microsoft, and Nvidia, and Tesla.
As I mentioned earlier, Francois, since U.S. stocks have massively outperformed, trade Investors have chased performance and allocated more to that asset class. But there is a flip side to all this outperformance, and that is valuation. The U.S. stock market is a lot more expensive than International stocks, even after the recent underperformance. Again, quoting from the WSJ article by Randall Smith, according to Yardeni Research: “… at a current multiple of 23 times expected future earnings, a healthy premium to International stocks (ex-US) at 14 times, based on market prices as of July 2.” US stocks remain overvalued by many historical measures.
François Doyon La Rochelle:
James, it can also be said that International stock markets have not produced Magnificent Seven-type companies to help drive returns. Some believe U.S. exceptionalism is at play. The U.S. has very well-developed early-stage venture capital and private equity markets that other countries simply can’t compete with.
But James, do you have some insights to share about U.S. stock market valuation and outperformance based on longer-term statistical evidence?
James Parkyn:
Yes, I do, Francois. Recently, Antti Ilmanen, Principal and Global Co-Head of Portfolio Solutions Group at AQR, the big U.S.-based Institutional Investment manager, published a Report titled Exceptional Expectations: U.S. vs. Non-U.S. Equities.
The Reports decomposes historical US outperformance into three components: yield, growth, and valuation change. It addresses the question of U.S. vs International Stock allocation by analyzing the drivers of relative performance, in particular the different roles of fundamentals and valuations.
François Doyon La Rochelle:
James, I like the fact that they highlight the debate in recent years among large global money managers and how to allocate funds to global equities. Specifically, the ongoing challenge they face is how to respond to persistent US outperformance. The Report states: “Some global money managers maintained market cap weights despite ever more extreme relative valuations, others pursued the contrarian view implied by yield-based expected returns, and yet others gave up entirely on the rest of the world, as the US seemed so strongly placed to foster technological innovation, earnings growth and investor returns.”
James Parkyn:
The Report highlights that there are several counterarguments. It shows how US outperformance since 1990 primarily reflects rising relative valuations. I quote: “By the end of 2024, relative valuations were at a historically extreme level, and we argue that some mean reversion is a sounder assumption than extrapolation of further richening.”
François Doyon La Rochelle:
For our Listeners, James, I would add that for the period from the year 2000 to 2010, the US markets had a lost decade and underperformed the rest of the world, that includes the financial crisis period. U.S. Markets have also underperformed for other extended periods, for example, the decades of the 1980s, and 1970s. That said, the Report highlights and I quote: “the US has enjoyed an average return and growth edge over the past 50 or 100+ years—though not as large as implied by recent valuations. We suspect that the recent high valuations and predicted abnormal growth edge partly reflect investors mistaking the richening-driven return outperformance for growth-driven outperformance (which would be more reasonable to extrapolate).
James Parkyn:
François, one of the main findings of this Report is that US stocks have a long-run growth edge of around 1% p.a. over the past century, but in recent decades their return edge has been significantly boosted by relative repricing. The long-run annual return edge is near 2% but outperformance has been much larger since the GFC, mainly reflecting relative valuation change but also a larger growth edge and dollar appreciation.
I want to quote the Report: “The combination of using a short rearview mirror and ignoring the impact of valuation changes can make extrapolative investors form overly optimistic expectations on the future US growth and return edge. Even the past decade’s exceptional US growth edge is not good news for the US, since both valuation changes and abnormal growth have negative autocorrelation at a decadal horizon. Subjective growth expectations are often extrapolative, but objectively, a strong decade of growth predicts a weaker decade.”
François Doyon La Rochelle:
That is a great quote. To me, James, the Report’s main message is that the US has had a long-run growth edge of, say, 1% The Report also states that it is likely fair to assume some edge going ahead, but it seems that markets are discounting a much larger growth edge.
James Parkyn:
That leads to the question: How much larger? The Report tries to answer the question from another angle. It looks at what growth edge would be needed over the next decade for the US market to deliver the same return as the non-US market, assuming no change in valuation of either market. The result using AQR’s capital market assumptions as of December 2024 is a required growth edge of 2.2% p.a. for US equities to earn the same return as International stocks.
François Doyon La Rochelle:
This is a really important takeaway from the Report. It states: “few investors appreciate how much of the past absolute and relative performance reflects repricing, which really should not be extrapolated – especially when today’s extreme valuations point the other way. Rearview mirror expectations may be strongest just when they are most dangerous.”
We need to remind our Listeners, James, that as Canadian investors, there is a compelling case for diversification within stocks. Our model is 20% allocated to Canadian stocks, 50% to U.S. stocks, and 30 % to international stocks. The balance between U.S. and International stocks is in line with their share of global market capitalization. That works out to about two-thirds in U.S. stocks and one-third in International stocks.
James Parkyn:
We have always had a strong U.S. stock allocation. We have rebalanced over the years to maintain that weight. Some clients are now also asking us if we want to reduce this exposure. The short answer is no, we don’t. This would smack of market timing or forecasting the future. For some clients in particular circumstances, we can increase or decrease the weights of their allocations relative to our model allocations.
François Doyon La Rochelle:
Finally, James, what takeaways do you have for our Listeners concerning Global diversification?
James Parkyn:
Right now, there is a lot of negative sentiment about U.S. stocks, particularly with non-American investors. As we like to do on this Podcast, I will share a quote from Warren Buffett: “Never bet against America”. By the way, he has said this often over the years. More recently, he wrote about his strongly held belief in his 2021 Letter to his Berkshire Hathaway shareholders.
François Doyon La Rochelle:
James, in his letter to shareholders, stated: “Despite some severe interruptions, our country’s economic progress has been breathtaking. Our unwavering conclusion: Never bet against America.” Keep in mind that Buffett also said the conglomerate owns the largest amount of U.S. assets (property, plant, and equipment) by value than any other company in the country.” I guess we can say he walks the talk.
James Parkyn:
Another thought I want to share with our Listeners is also from our Podcast #75. Since 2000, when markets have been deeply volatile, they have tended to move together. But the potential risk reduction benefits from international diversification are real. The UBS Yearbook shows that over the last 50 years, globally diversified portfolios generated higher Sharpe ratios than investing in domestic investments in the vast majority of countries. For our listeners, the Sharpe ratio is a measure of an investment's risk-adjusted return, essentially indicating how much return the investment generates for each unit of risk taken.
François Doyon La Rochelle:
There is nothing new here, Francois. As we have often discussed in our Podcast, diversification is a key part of our investment discipline. The power of diversification across stocks, markets, and asset classes helps to reduce but not eliminate risk.
Over the last 50 years, except for US-based investors, investing globally for investors has led to better risk-adjusted returns than investing only in their home markets.
James Parkyn:
As our regular Listeners well know, we have experienced four equity bear markets since 2000, and we need to be paid for taking risks. The risk premium for investing in stocks exists for a reason. It is a necessary payment for the risk of volatility and drawdown.
François Doyon La Rochelle:
Good investment decisions, based on sensible criteria, can sometimes have disappointing outcomes. This brings us back to James's importance of a long-term perspective and with it an appreciation of the laws of risk and return. I recommend that our listeners always consider their long-term goals, their risk profile, their ability to take risks, and their time horizon when building their portfolios.
I hope our Listeners have found our discussion about Allocation to US vs International Stocks useful in helping them make smart decisions with their long-term money. Investors must always come back to the perspective of risk and reward, and the importance of diversification and asset allocation. This, as our Regular Listeners know, is core to our Investment Philosophy.
3) CONCLUSION
François Doyon La Rochelle:
Thank you, James Parkyn for sharing your thoughts and expertise again today.
James Parkyn:
My pleasure, François.
François Doyon La Rochelle:
That’s it for episode #78 of Capital Topics!
Do not forget, if you would like to submit questions or suggestions for the show, please email us at: capitaltopics@pwlcapital.com
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