By Gary Brooks, CFP®
Why invest in stocks outside the U.S. if the S&P 500 already represents a meaningful amount of foreign revenue as U.S. companies participate in the global economy? It’s a common question, especially when investors with globally balanced portfolios look at recent U.S. stock returns compared to foreign stocks.
I’ll attempt to answer this with four visuals.
First, the U.S. stock market is diverse and globally inclusive. But it represents just a bit more than half of the 12,000 publicly traded stocks in 44 countries.
This graphic makes the size of the U.S. market clear but it should be just as clear that many quality companies are headquartered outside the U.S. and competing very well in the global economy.
After you understand that the size of the international investment opportunity is large, next it’s important to understand the rotation of global market leadership over time. U.S. stocks do not always outperform international stocks the way they have recently.
If history has any value as a guide, it seems logical that international stocks will shift back to leadership at some point after U.S. leadership the past several years. This chart from Vanguard shows clear precedent for rotation over the past 45 years. Blue periods show international markets outperforming the U.S., green vice versa.
Another reason to expect non-U.S. stocks to generate better forward returns than U.S. stocks is the relative value of current market prices. CAPE stands for cyclically adjusted price earnings ratio. It looks back at actual company earnings for the past 10 years. The higher CAPE ratio, the more expensive the market and the lower the expected future return. In the table below, you can see that U.S. stocks have a high CAPE (25.5) compared to other countries (as of 9/30/16). In this forecast, the forward expected return (average annual return over the next 10-15 years) is just 4.2% for the broad U.S. stock market. Basing value on price/book ratio yields a similar forecast.
Alternatively, non-U.S. developed markets have a lower CAPE (20.9) and higher forecasted return (5.6% avg annual) over the next decade plus. Emerging markets present the most attractive valuation (as of 9/30/16) with a CAPE of 14.4 and forecasted return of 8.2% per year.
These return assumptions represent probabilities based on past returns from the same CAPE ranges. There is uncertainty and randomness in returns making the forecasts imprecise.
The next chart shows a deeper level of detail. It is clear that the lower the starting CAPE (shown in ranges at the top of this table), the higher the future realized return. Blue fields represent higher returns than red. This is consistent across countries.
This is why we believe that participation in international markets is important, particularly at this time.
Looking at performance over the past 1, 3, or 5 years comparing U.S. markets/funds to international markets/funds doesn’t tell the same story because recent returns weight toward the recent U.S. market leadership.
Vanguard research suggests that the optimal weight of international stocks in a U.S. investor’s portfolio is roughly 1/3. For an investor with 70% of their portfolio in stocks this would equate to 46% U.S. stocks, 24% foreign.
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