The U.S. dominance over equity markets is coming to an end, says Dan Villalon of AQR Capital Management, the $95 billion quant hedge fund founded by well-known quantitative investor Cliff Asness. In an interview with Bloomberg, Villalon said that the models used by AQR indicate that equities in emerging markets have the cheapest relative valuations since the year 2000, and will beat U.S. equities for the next 10 years.
Investors should drop their overweight U.S. equity holdings in favor of emerging-market stocks; even with any headwinds, “this is about as attractive as we’ve ever seen for emerging equities,” Villalon told Bloomberg, especially for active investors who lean more toward value. Stocks from developing countries have underperformed U.S. stocks for the last 6 years, and though the MSCI emerging markets index has climbed 5% this year, that’s not anywhere near the S&P 500’s rally of 14% or the Nasdaq 100’s jump of 38%.
While U.S. equities outperformed emerging-markets shares, U.S. investors didn’t have much incentive to invest overseas. However, that outperformance was due more to investors’ desire to pay more for U.S. investments rather than fundamentals, AQR models show. Now the model indicates that the likelihood of more outperformance is slim. AQR takes “a valuations-based perspective,” Villalon says, so while the firm can’t predict “if the U.S. is going to continue to outpace emerging markets next year,” they can highlight their belief that “on average over the next 10 years, EM equities based on valuations should be the relative victor comparing the two markets.” Factoring in inflation-adjusted earnings as well as long-term dividend payment rations in relation to market prices, AQR’s model shows that emerging-market shares are much more inexpensive than what a simple analysis using price-to-earnings ratios might indicate.
Most investors that Villalon has encountered have a significant tilt toward U.S. equities, and AQR’s goal is “to get people to reconsider that,” he told Bloomberg. Investors should think about bringing their U.S. equities weight back to neutral, or even weighting more towards undervalued emerging markets. Though U.S. equities may still outperform emerging markets in the short term, investors should still rethink their portfolios if they have a heavy focus on U.S. equities. While diversification beyond domestic borders can be complicated, “it’s an especially important part of building a more efficient portfolio,” Villalon advises.
