Should I Own International Stocks?

Why own international stocks? Especially when, as noted in Exhibit 1 below, US stocks have outperformed international stocks over the last one, five and ten years, respectively.  After all, most investors would have been better off only investing in US stocks the last ten years and not worrying about international diversification.

 

It’s times like these, when it’s easy to forget that all too famous investing warning “past performance is not indicative of future results”.  This led us to read between the performance lines to answer the question, Why Have US Stocks Performed So Well? Our research helped us see some unique drivers of recent US stock returns and potential risks going forward.

Timing Matters

Exhibit 1 shows us the last ten years for returns, but what about longer time periods?  As noted in Exhibit 2 below from December 31, 1969 through December 31, 2016 the annualized results between US and international stocks are within 1%.  If we change the ending date to December 31, 2007 international stocks have actually had higher returns than US stocks over this time period.

US vs International

Investors have understandably become impatient with international equities, given years of lagging returns compared to US stocks.  Furthermore, news from international markets are typically negative considering events like the Brexit vote, China stock market volatility or overall slow growth in Europe or Japan.  However, taking a long-term view and understanding that extended periods of lagging results have tended to be followed by extended periods of higher relative returns as noted in the chart below.

You’ll note that periods of strong returns relative to the US stocks is typically followed by periods of low returns.  The data above ends on June 30, 2016, but we saw the same trend through the end of 2016.  Not to mention, the current trend of US stock outperformance is currently the longest on record.

Valuations

As you can see US vs. international results go in cycles, but what about valuations?  If US stocks are cheaper than international stocks it would still make sense to own mostly US stocks.  The valuation numbers don’t reflect this as noted in Exhibit 4 below.  We reviewed three different valuation indicators to determine the difference.    Why look at valuations?  Because they have a very strong correlation to long-term returns (see Exhibit 5) as the lower the price you pay the higher the future returns and vice versa.  Keep in mind for all three indicators a lower number means cheaper.

Valuations

So international stocks are cheaper than US stocks, but is there any correlation to future returns?  Yes, according to the CAPE ratio as noted in Exhibit 5 below comparing historical starting CAPE ratio compared to future 10-year real returns.  You’ll note that when prices are cheaper, future ten year returns are higher.

10 Year Real Returns

US stocks are in the >25 category while international stocks are in the 10-15 category as noted by the X axis above.  Historically, from these valuation levels median stock returns in the US category have returned approx. 2% real (before inflation) and the international category have returned 8% real.  International stocks are not cheap, but do seem to be a better value today than US stocks.

What To Expect?

Finally, how do other industry experts feel about future potential returns between US and international stocks.  See Exhibit 6 below regarding their future projected equity returns over the next five to ten years.  You’ll note all four respectable industry sources expect higher returns from international stocks.

Expert Predictions

Source:  Morningstar

These are projections over the next five to ten years as anything can happen in the short-term.  That being said I’m reminded of a quote from one of my idols, Wayne Gretzky, “skate to where the puck is going, not where it has been”.  I find a lot of similarities with that quote and the current investing environment.  You can either chase what has done well (US stocks) or go where we think the puck will be (International Stocks).

Finally, although we feel international stocks are a better value today – they are by no means cheap – but a better value than US stocks. We expect the investing environment for the next five to ten years to be challenging given recent investor expectations.  Therefore, it is important to maintain discipline, reasonable expectations and a focus on your long-term financial plan.  Don’t have one?  May be a good time to contact a fee-only financial planner.

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