Diversify, diversify, diversify
How to mitigate the risk of a US stock bubble implosion
The following is for educational and informational purposes only, and is not a recommendation to buy or sell shares. When buying or selling shares, investors should do their own research and seek independent financial advice if necessary.
In this update:
A list of things to avoid
A range of things to consider
My last two articles looked at the size of the US stock market bubble and some factors that are likely to have contributed to it. If you missed them, then I recommend that you read them before continuing.
More reasons to fear the US stock bubble.
(Note that the latter parts of them are restricted to paid subscribers only.)
Today I’ll share my thoughts on what investors can do in order to mitigate the risks of the US bubble bursting (for paid subscribers only, once we get to the meat).
Lots to get through. But the risks of the current situation warrant it.
To be clear: I don’t know when the bubble will burst. No one does. The bubble could keep inflating for a couple more years, making it even more dangerous. Or it could start to burst quite soon.
It’s just a question of when a pin will appear to pop it. We don’t yet know what that pin will be. But it will surely appear at some point.
Also to be clear: I don’t believe that long-term investors should get out of stocks entirely, or stocks of non-US companies that generate significant profits in the US, or even all individual US stocks necessarily (if value can be found).
But I do believe that they should tread very lightly in the pricey US stock market, and generally avoid US index funds at the moment.
In total, across all of my current stocks - wherever the companies are headquartered or the stocks are traded - I estimate that 20% of the underlying revenues and/or profits are generated within the US (weighted by the size of the investments). I’m comfortable with that.
Overall, I am invested currently in 22 stocks, across around 17 different business sectors (subject to slightly fuzzy boundaries sometimes), trading on six different country stock markets, of companies headquartered in 11 different countries.
Their combined businesses are spread across multiple continents (mainly North America, Europe, and South America, plus a little of Asia and even Africa), and dozens of countries.
(Combined company profits generated in Greater China - being mainland China, Hong Kong and Taiwan - are only about 1% of the total. This is deliberate due to the obvious risks of a geopolitical flare-up at some point, although surprisingly hard to achieve in a globalised world. I note that Taiwan test-launched US-made missiles in the direction of China just last week, for the first time.)
The most valuable company has a market capitalisation of $252 billion. The smallest is a micro-cap stock with a market capitalisation of about $95 million. Some stocks are high-growth, some are quality, some are “growth at a reasonable price” (GARP), some are deep value / high dividend yield.
The result is that risks are spread across geographies, stock market listings (index inclusion), business sectors, company sizes, and stock types (high growth through to high dividend yield).
That is due to very deliberate and active diversification, but only across stocks that each make sense to me in their own right. I believe that this sort of diversification is more important than ever these days.
The world is uncertain for a range of reasons. And the giant US stock market is in a clear bubble. When risks are high it makes sense to spread your bets widely, and not just across diversified stocks.
I’ll start by looking at things that I believe are best avoided. Then I’ll turn to things that look sensible, especially if packed together in a diversified and patient investment portfolio. Put another way, each element is intended to serve a distinct purpose under different future conditions.
Things to avoid
Most investors and advisors focus on what to own. But all investors should always start by thinking about what to avoid. Then they can look at how to spread their capital intelligently between what’s left.
Howard Marks, the veteran bond investor and Co-Chairman of Oaktree Capital Management, has referred to this as the “negative art” of bond investing. That’s especially when it comes to junk bonds, these days usually called “high-yield” bonds (his speciality). By avoiding the bonds that are most likely to default, the portfolio should perform well.
I believe this approach should be applied to stock investing as well, and in fact across all investing, whatever the asset class. By doing our best to avoid the losers we’ll do better overall.
In other words, investors should set a high bar before they invest in anything. And they should never diversify just for the sake of it, into investments that are likely to give bad results over time. (Also sometimes known as “diworsification”.)
This is not to say that any of us will always get it right. But it’s essential to at least try to avoid the duds.
But note that when I talk about things to avoid, I can’t be certain that they won’t perform well in future. Anyone that claims otherwise is lying to you. There is no certainty.
Investment alternatives in this bucket, in my opinion, are simply ones where there are enough reasons to think that they won’t perform well. By which I mean the foreseeable risks of loss outweigh the chances attractive profits.
This is what investors always have to do. Weigh up the chance of profit with the risk of loss. Get it right on average and you’ll have a good outcome.
Very expensive stocks are higher risk than very cheap ones, all other things being equal. Put another way, risk is not independent of price. It is positively correlated.
Higher prices equate to higher risks of sharp subsequent price drops. Lower prices equate to a higher chance of large future price gains. (Again, all other things being equal.)
The stock of a great company with reliable but modest growth may make sense with a price-to-earnings (P/E) ratio of, say, 15x. But the same stock can be a highly risky investment with a P/E of, say, 30x.
Just ask anyone that invested in overpriced quality stocks in late 2021 / early 2022 and watched the prices implode as bond yields rose. Take a look at the long-term stock price chart for Nestlé (Swiss:NESN.SW), the world’s largest food and drink company, to name just one example.
Another stock of a very high growth company may make sense with a P/E of 30x, but perhaps is best avoided with a P/E of 60x. The stock of a very mature and low growth company, with a high dividend yield, could make sense with a P/E of 8x, but not at 16x (when the dividend yield would be half as much).
The assessment of which stocks are cheap or expensive has to happen on a case-by-case basis. It should take account of factors such as future company growth prospects, dividend yield, the size of net stock buybacks (i.e. after stock issuance to company insiders), corporate debt levels (i.e. financial strength), cash conversion (how much of reported profits turns up in free cash flow), competitive threats, and so on.
But the basic reality remains in all instances. Cheap is lower risk, expensive is higher risk.
Given that the US stock market is now so expensive, it also means that it’s much higher risk than average. This is not the same as saying that US stocks must crash. It just means that it’s much more likely at some point, and the size of the drop could be very large.
With that, let’s get into the specifics of what I think is best avoided at the moment.