Is It Time to Diversify Beyond US Large-Cap Growth Stocks?

The market is melting. Since the election, nearly every risk asset with a pulse has gone up.

What’s driving this? Morningstar chief multi-asset strategist Dom Pappalardo attributes the rally to expectations around tax cuts, deregulation, and a more business-friendly environment. But markets often swing like a pendulum, and this rapid ascent raises the possibility that caution is being thrown to the wind. The Chicago Board Options Exchange’s Volatility Index, often called the “fear index,” is down nearly 40% since late October.

In other words, fear is leaving the market.

In August, we covered the opposite scenario when VIX saw a three-day spike of 135%—one of its largest jumps ever. We wrote: “When VIX is making new all-time highs ... the data is overwhelming: Be a buyer, not a seller.”

Now we’re seeing the reverse. The VIX is falling like a piano from the sky. What does this mean? Without rendering an exact prediction, it’s reasonable to conclude this is not behavior typically associated with market bottoms. Morningstar chief research and investment officer Dan Kemp recently wrote that the rise in equity prices has driven US stocks “further into overvalued territory.”

In short, when you mix in some euphoria, an overvalued US stock market, and a full calendar year without a correction, there’s a logical case for diversification beyond US large-cap growth stocks. That said, the market gods are always trying to make fools of us. Momentum is a very real market factor, and what has gone up recently may continue to climb. No one is saying a sea change will happen tomorrow or next week. However, when the market does pivot, no bell will ring to signal it. We can’t predict the timing, but we can prepare, and preparation is always an ongoing process.

What does this mean in practical terms? For US markets, it might involve reducing allocations to large-cap growth stocks in favor of a broader approach. This could include “value” stocks—cheaper large-cap companies—and increased exposure to small- and mid-cap stocks. It might also mean expanding allocations to other parts of the globe.

For example, as Barron’s recently pointed out, emerging markets represent 85% of the global population and 60% of global GDP, yet only 10% of global equity market capitalization. Despite this, US investor portfolios allocate only around 2% to emerging markets on average. If the performance gap between the US and other regions starts to shift, a wave of US buyers will likely move to increase their allocations abroad.

While the market backdrop appears less risk-averse, investors might be better served by doing the opposite. A day will inevitably come when US stocks hit a rough patch, and broader diversification could be the best way to prepare for it.