"Why not just buy the S&P and forget about it?"
Honestly, it’s a fair question, and at first glance, the logical answer seems to be, why not? US equities are quietly having one of their best years since the 90s. If you look at the S&P 500’s performance over the past 20 years, not only is this the best year so far through the end of September, but if you look at the top-ranked full calendar years, 2019, 2021, and 2023 all rank in the top four.
Whether it's been a conscious decision to overweight US equities or simply the result of market growth and increasing model exposure, it’s no surprise that portfolios are so heavily tilted toward US stocks. Why wouldn’t they be when the market keeps rewarding that choice? It hasn’t been a mistake by any means. The S&P 500 total return index is up 64.5% in just two years.
I mean, saying that out loud almost sounds ridiculous, but after 45 new highs in 2024, here we are!
Investors seem confident that the market will keep cruising along, but what if it doesn’t? Call me crazy, but it has happened a few times before. What if an unforeseen market event comes along, and the market takes a hit like it did in ’08? That kind of 50% pullback would cause devastation and wreck many retirement plans. While the current environment seems flooded with liquidity, there’s no guarantee that dip-buying will always be there to save the day. We may sound like a broken record, but our goal is to continue to bring awareness to underlying portfolio exposures that not all portfolio managers may be aware of.
Surprisingly, very few portfolio managers think they are overweight US exposure. We conducted a small survey, and out of 18 respondents, only two believed they were overweight. The rest of the respondents were split between underweight and neutral. Of course, the question was framed subjectively and is solely based on what you believe the US equity baseline should be for your portfolios. Still, for only two people to suggest they are overweight, leads me to believe that the average baseline for US equities is much higher than we would believe.
The baseline for US equity exposure has to have changed if 88% believe they are underweight or neutral. We reviewed 42 portfolios and compared them to our own baselines and models, and US equities, from our perspective, are overweight for most folks. But again, this is subjective. When compared to our baseline of 30%, the 46% average advisor model weight is significantly higher. Even if you bump up your baseline from 30% to 40%, there is still likely too much US exposure. If we consider anything up to 35% neutral, 79% of portfolios we review from our standards are overweight US equities, whereas 11% of survey respondents believe they are overweight US equities. The numbers aren’t adding up. Also, note the shocking range from just below 20% to almost 100% exposure within the US equity asset class.
It’s probably one of two things: either investors don’t realize how much their exposure has increased, or they are aware and are just letting it run with a baseline higher than ours – either of these scenarios makes sense, and even if investors are not aware of them, it has been the right call for over a decade. After such a long stretch of success, it’s no surprise that investors have grown comfortable. Anchoring bias has led most of us here to focus on the recent strong runs of the S&P 500 so much that we have forgotten that similar returns have been found across the globe. Maybe it's time to rebrand anchoring bias as "comfortability bias."
But what about moving forward? We know the direction of rates in the US economy, and there’s a lot of hype around rate cuts being a boon for the market, but history shows it’s not that simple. Logical thinking might suggest that, with lower rates, stocks will do well. Borrowing becomes cheaper, and earnings start to improve, and over the long run, this is true. However, it is much more nuanced in the short term, and it is important to understand why the Fed cuts have a big impact. Look at what’s happened to the S&P 500 the last four times the Fed started cutting rates. The year before the cut, the market was up three out of four times. The one-year forward returns show a 50/50 shot of a negative or positive return. This year, we’re seeing the best pre-cut performance in the last five cycles, but what happens next is anyone’s guess. We can expect the effects of these rate cuts will likely play across markets for quite some time. The “Fed playbook” is there, but just like any other playbook, sometimes that play gets blown up.
Without having a lot of data to evaluate for rate-cutting cycles, understanding the “Why?” for the Fed is important. The Fed's reasoning behind rate cuts can drive market reactions differently depending on whether it's a precaution against a recession or a routine policy adjustment. While some of the potential benefits of rate cuts may already be reflected in current stock prices, market volatility is expected due to ongoing uncertainty. Regardless, the market's response will not be very predictable in any environment as the Fed navigates these inflection points.
Final Thoughts
The bottom line is that portfolios are rightly or wrongly loaded up on US stocks, and while that’s been the right call for a while, it’s difficult to say if it will continue to be. As stated before, what you consider a “neutral” US allocation is subjective. It might differ from ours, but based on the data, most portfolios are far from what should be considered neutral. Keep an eye on your portfolio weightings, as there are many global opportunities to explore, and diversification remains a key strategy for long-term success. With increasing risks and high valuations, it might be time to rethink those weightings. We advocate for a more balanced approach. With valuations stretched, as noted in the previous section, the potential for disappointments is elevated.
— Brett Gustafson is a Portfolio Analyst at Purpose Investments
Sources: Charts are sourced to Bloomberg L.P.
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