Our focus at Litman Gregory is not on macroeconomic forecasting. We're investment analysts, not economists. There's an important distinction between thinking about the economy and thinking about the financial markets. It's vital to understand that macroeconomic cycles have not coincided with financial-market cycles. This insight is particularly relevant to asset allocation today.
Case in point: The U.S. economy has certainly recovered moderately from the financial crisis of 2008/2009. It is clearly the strongest developed market economy in the world and has been the engine driving global growth. In contrast, Europe has really struggled. They had another recession in the intervening years that they are just now recovering from, but growth is still below 1% (versus U.S. growth of 2% to 3%). And there are deflation fears and a looming debt crisis in Greece. So if the U.S. economy is so much stronger, why not invest more in the U.S. stock market?
The answer is because you have to analyze the stock market separately from the economy. Stock prices in the markets of strong economies can be higher than they should be even based on great fundamentals, and stock prices in the markets of weak economies can be cheaper than they should be. Higher prices now mean your future gains will be lower, all else equal. This is how expected financial market returns can decouple from prevailing macroeconomic conditions.
Our analysis of U.S. stocks, incorporating growth and price, suggests the returns we're likely to earn from investing in them going forward are in the low single digits over the next five years, much lower than the 9% or 10% they have returned historically. We would have to be expecting that type of return in order to be at our full exposure level to U.S. stocks, regardless of economic strength. We think the risk side of the equation has not changed. The risk that comes with owning U.S. equities is as high as ever; stocks can drop 20% to 30% over 12-month or shorter periods. The risk hasn’t gone down; only the return potential has.
Europe has problems from a macro perspective, but the stock market there is still attractively valued. When we run through our analysis for European stocks, we estimate a return in the low double digits over the next five years. We know we're not going to get it precisely right, but the gap between our expectations for U.S. and European stocks is huge. While Spain, France, or Italy may seem like economic basket cases, there are companies based there that are world-class businesses. They have been knocked down just because people don't want to invest in Europe from a macro perspective.
Most Americans like to buy things on sale. We usually get attracted to something when it's cheaper or on sale, not when it's more expensive. Somehow the stock market seems to have a different effect on people. As the market goes up, more people start piling in. They want to buy stocks at higher prices because they've seen how well they’ve done in the past. A better approach is to seek out investment opportunities where prices are lower and prospective returns are higher.