Inside today’s Daily Journal…

Americans have virtually all of their wealth (94%) exposed to the same major risk.

They’re not being paid to take this risk. And, in fact, most investors would claim it doesn’t even exist. But it certainly does, and right now it poses an existential level of danger for many investors.

What’s the big risk? America. Most American investors have zero exposure to any other equity market in the world. They only invest here. Today, that’s a huge risk.

America’s current Shiller CAPE ratio (a cyclically adjusted price-to-earnings multiple that smooths a decade of real earnings) sits above 40. The long-run average is 18! American stocks have only been this overvalued twice before in the last 100 years: 1929 and 2000. Neither of those periods worked out well for most investors.

My friend Meb Faber has done the most sophisticated research on the impact of global versus U.S.-only investing. He studied every country that ever saw a CAPE of 40 – the U.S. in the late 1990s, Japan in the 1980s, China and India in 2007. In every case, the subsequent 10-year real returns averaged about zero. Not once, in all of market history, did a country reach a CAPE above 40 and go on to deliver even an average decade.

The other thing that happens at market extremes is what analysts refer to as “concentration.” The extreme risk in America’s market is not spread evenly. It is concentrated into a handful of names. The 10 largest companies in the S&P 500 now account for roughly 40% of the entire index, a concentration that eclipses the dot-com peak and stands at the highest level in five decades. Forty cents of every dollar flowing into passive index funds is now buying only 10 stocks. And virtually all of them track their sales and earnings back to information technology.

That is not diversification. That’s a massive bet on one investment trend. And that investment trend has shifted from being equity-financed to being debt-financed. That makes the risks even bigger.

The traditional shock absorber Americans have used to mitigate equity risk – bonds – are no longer investable. Since 2020, long-term U.S. Treasury bonds – the asset that was supposed to protect portfolios when stocks fell – have endured their worst bear market in the history of our Republic. The Treasury total-return index has been underwater for roughly 69 straight months, more than double the previous record. The iShares 20+ Year Treasury Bond ETF (TLT) has fallen 50% from its 2020 peak, a loss deeper than the S&P suffered in 2008. So, the 60/40 stock-and-bond portfolio that a generation of advisors sold as “safe” took its worst beating since the 1930s. And that beating isn’t over.

Add the geopolitical risk – a dollar-based order that half the planet is now openly working to route around, sanctions weaponized, trade blocs redrawn – and the picture is complete. Extreme valuations, extreme concentration, a broken hedge, and a shifting global structure. This is precisely the configuration in which a single-country bet can wipe out a generation of investors.

And yet, “Homer” still invests only in America.

Meb Faber’s numbers reveal why that’s such a big mistake. Today, American stocks make up more than half of the world’s equity valuation, but the U.S. economy is only about 25% of the world’s gross domestic product (“GDP”). The U.S. stock market isn’t merely overvalued. It is overvalued relative to those of other countries by the largest amount ever. Meanwhile, emerging markets hold 85% of the world’s people and, by Faber’s math, close to 60% of its economic output. Yet emerging-market stocks make up only 10% of global stock market value… and Americans own virtually none of those equities.

Keeping 100% of your eggs in one country basket opens you to a bona-fide existential risk. An investor who put everything into the German stock market in the early 20th century, or the Russian market, or the Chinese market, saw his wealth permanently erased. Not dented. Erased. Germany, China, and Russia all have equity markets that went to zero in the last 100 years.

But these extreme cases aren’t the biggest danger. The biggest risk is what happened to Japan.

In 1989, Japan was the second-largest economy in the world. It had the largest and most sophisticated financial markets, including the largest global banks. It was the largest stock market on Earth, 41% of the world index, trading at a CAPE near 100. Nearly four decades later, the Japanese stock market still hasn’t gotten back to breakeven. That’s an entire investment lifetime with zero return and massive real (after inflation) losses.

The lesson is that the most expensive, most beloved, most heavily weighted market is exactly the one you least want to concentrate in – and today that market is the United States.

But that doesn’t matter to Homer. He will only invest in America, or as Faber says, he has “home country bias.”

I began my career in finance as an emerging-markets analyst. For years, I traded in Latin America’s seven major markets and in Asia ex-Japan. These markets are extremely volatile and there are many pitfalls. But there are also many world-class businesses that trade for peanuts. And there’s a very obvious way to sort the wheat from the chaff – a way that dramatically reduces risk and volatility too.

And here’s the good news. Financial risk has become extremely concentrated in developed markets. Emerging markets have rarely been this attractive relative to developed markets. In fact, going back to 1980, the U.S. and foreign markets have carried nearly identical average CAPE ratios of about 22 – the historical valuation premium for owning America has been exactly zero. But today that spread is one of the widest in 40 years. Foreign developed markets trade in the high teens to low 20s. Emerging markets sit around 14. The cheapest quartile of countries trades near 11 – roughly 60% below the U.S. – and that cheapest bucket returned about 55% last year.