Why There Will Be More Foreign Stocks In Our Future

Feb 19, 2015
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At least as far back as 2007, we’ve been explaining that the globalization of the world economy and financial markets has been pushing more of the opportunity for investors outside the U.S. From our January 2007 new allocations article:

This gradual increase is largely due to the increasing globalization of the financial markets. The rapidly expanding middle classes of countries around the world point towards exciting international growth prospects of a scale unprecedented in modern times.

Unprecedented...a little dramatic, perhaps, but I was an excitable youth back then. Of course, events interrupted this vision of the future — namely a global financial crisis and extraordinary government/central bank actions, both of which conspired to make the U.S. a particularly attractive investment destination in recent years. And let’s face it, it’s not as if anyone is arguing the U.S. is going to stop being a worthwhile investment destination. Rather, the argument is simply that there’s more opportunity overseas than ever.

Given that foreign stocks have performed so poorly relative to U.S. markets the past few years, it may seem an odd time to bring all this up. But it’s actually because foreign markets have performed so poorly relative to the U.S. market in recent years that it’s worth talking about now. And I’m starting to see an increase of smart investment people doing exactly that.

The issue can be boiled down quite simply to that of relative valuations. While the U.S. stock market has been earning huge returns in recent years, foreign returns have been much more muted. This is clear when looking at the past 5 years of returns from the S&P 500 (SPY) and Foreign Stock (EFA) vehicles that our Dynamic Asset Allocation strategy monitors. Over the past 5 years, EFA has earned 7.1% annually, while the SPY has earned 15.96% annually! When you compound those returns, EFA is up a total of 40.9% over the past 5 years, while SPY is up 109.6%.

The result of a period of relative imbalance like this is valuations get out of whack, which is exactly what has happened here. U.S. stocks are trading at historically expensive levels, whereas most foreign shares are much more reasonably priced. We’re not superfans of the cyclically-adjusted price/earnings (P/E) ratio (taking a 10-year look at earnings and prices instead of just measuring the most recent 12 months), but it is a decent valuation measure for looking at relative valuations like these. By that gauge, the U.S. market’s P/E is 26, whereas the U.K. and Europe are a little below 16, and emerging markets are under 14. Those are huge disparities.

I’ve mentioned recently that in the past, when interest rates rose, P/E ratios have tended to fall. Investors aren’t willing to pay quite as much for each dollar of earnings as they were when interest rates were lower. Most people think the Fed raising interest rates is a matter of when, not if, and if that turns out to be true, it’s reasonable to think U.S. stock P/E ratios will come down. That doesn’t necessarily mean stocks would have to fall (a lower P/E ratio applied to higher earnings could allow the market to still move higher). But whether the U.S. market goes down to close that gap or merely faces stronger headwinds which cause it to advance more slowly than foreign markets, it’s not hard to see this valuation gap narrowing eventually, and foreign stocks starting to outperform U.S. stocks.

Last September we ran a cover article titled Why Your Portfolio Needs Foreign Stocks, largely in an effort to combat the growing negativity that comes when an asset class underperforms for as long as foreign stocks have. And as I mentioned earlier, I’m starting to see this theme coming up more and more as I’m reading other top investment thinkers. A few examples:

Ben Inker, GMO - "Investing where the valuations are lower has been a far better strategy historically, and, despite all of the worrying features of the economic environment outside of the U.S. today, we believe that investing in the various bad and ugly places in the world is going to wind up far more rewarding than the admittedly good-looking U.S."

Brett Arends, MarketWatch, Why the U.S. stock market is one of the most dangerous in the world - "Wellershoff finds that many or even most overseas markets are either reasonable or a good value by historic standards. Apparent bargains can be found across a broad mix of developed and developing countries, and across multiple continents, from Mexico to France, and from Poland to Hong Kong. You can include those in your portfolio by investing in “international” (i.e. developed) and “emerging markets” funds alongside your U.S. small-cap and large-cap funds. Or you can just gamble on one market that looks really expensive, and hope for the best."

John Mauldin, Investing In An Age of Divergence - "First off, the US market is simply looking “toppy” to me. That doesn’t mean there is a crash or a bear market in the future (although that is a real possibility), but the outsized returns of the last four or five years are unlikely to be repeated. Will Denyer and Tan Kai Xian of Gavekal have made the case that it no longer makes sense to overweight US equities, which had been the firm’s position for many years:

Our issue is that three key drivers of US equity outperformance are going into reverse:

1) In recent years the Federal Reserve was the most aggressive liquidity provider in the world — this is no longer the case. In fact, the Fed is making moves toward tightening, while everyone else is easing.

2) In recent years the US benefitted from an extraordinarily competitive currency — this is no longer the case. In a very short period, the US dollar has gone from being significantly undervalued against almost all currencies, to being fairly valued against most, to now being overvalued against the likes of the euro and the yen.

3) In recent years US equities were attractively priced — this is no longer the case. On a number of measures the market is stretched.

"Even though the Federal Reserve rate hike has probably been pushed off into the third quarter, it will soon be priced into the market. Fed rate hikes usually lead to price-to-earnings (P/E) compression, whether or not there are strong earnings. But since almost half of S&P 500 earnings come from outside the US, a strong dollar is going to weigh heavily on those earnings. Procter & Gamble has said currency costs will reduce their earnings by $1.4 billion after-tax this year. They are not alone."

So if these other smart investors are increasingly saying foreign markets are presenting an opportunity, why didn’t SMI increase its Upgrading allocation to foreign stocks for 2015? Why don’t we own them right now in DAA?

As always when talking about big-picture shifts in the investing landscape, the question is when? If you’re an investor who is trying to decide what you should do today for your portfolio over the next 5-7 years, then sure, you would probably want to start adjusting things in the direction of more foreign stock exposure today. But that risks being considerably early regarding the transition and suffering poor relative returns while waiting for your prediction to come true.

Rather than trying to guess when this shift back toward foreign stock outperformance is going to begin, we think it’s better to wait until there’s actual evidence this change has begun before committing money to it. That’s the beauty of our trend-following systems — we can sit back and wait for the market to tell us this trend has shifted. Our mechanical strategies will automatically register such a shift, at which point we can make adjustments (by either adjusting our foreign allocation higher in Upgrading, or buying EFA when DAA signals it’s time to do so). After a solid January, foreign stocks lagged all four domestic risk categories through the first half of February. Maybe this trend will change rapidly, but it’s just as likely that it won’t. Either way, we’ll wait for the market to tell us.

That said, it’s a good thing to recognize these broader market trends. Prior to the financial crisis and the extraordinary governmental response to it, it seemed clear that over time, our exposure to foreign investments was likely to grow. After a breif interruption, it seems as though that may be ready to continue again soon. When it does, SMI’s strategies will be ready to take advantage.

Written by

Mark Biller

Mark Biller

Mark Biller is Sound Mind Investing's Executive Editor. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark also serves as Senior Portfolio Manager to SMI Advisory Service’s Private Client managed-account program and the SMI Funds.

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