Why International Stocks Are Now On Sale
If every year brought a fresh investing theme, then 2014 was a time for a “flight to quality.” An uncertain global economy led both foreign and domestic investors to focus on the safest and fastest-growing economy in the developed world: The United States.
#-ad_banner-#The S&P 500 once again scored double-digit gains and over the past three years, has generated a 21% annualized gain. That’s the best three-year showing since the late 1990’s. Bond markets also attracted lots of money, pushing yields back toward historical lows.
A sizable chunk of the gains in our stock and bond markets is the result of a tidal wave of foreign money flowing into our country. In October 2014, for example (the most current data available), foreigners spent a net $178 billion on U.S. assets.
The move, in hindsight, is quite understandable. Europe remains sickly; Latin America, Africa and Asia are seeing stiff economic headwinds; and geopolitical tensions in Russia and the Middle East remind us that we live in an unstable world. Although many markets lost value in 2014, the rising dollar made the impact even more painful for U.S.-based investors.
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The Wall Street Journal recently noted that the dollar’s impact on foreign stock and funds have turned local-currency winners into dollar-based losers.
The surging dollar is creating a strange triangular feedback loop between the United States, commodity prices and emerging markets. A rising dollar pushes the values of commodities down, and falling prices hurt the economy of commodity exporters in Latin America, Asia and elsewhere. Add it all up, and the dollar (and U.S. stocks) win, while other asset classes crumble.
When the feedback loop will stop is an open question, but it can’t persist forever.
Meanwhile, all that love and affection for U.S. stocks and bonds has erased any sort of appeal for value investors. The forward price-to-earnings ratio (P/E) on the S&P 500 is now around 16.5, according to FactSet Research. That’s more than the three most recent historical averages: five-year (13.6), 10-year (14.1) and 15-year (16.1). The forward 12-month P/E ratio hasn’t been this high since mid-2005.
Robert Shiller, a financial economist at Yale, prefers to use a “Cyclically Adjusted P/E Ratio” or CAPE, and by that measure, shares trade for more than 25 times earnings, which has only happened before in 1929 and 2000.
Shiller’s concerns are echoed by a traditional measure used by Warren Buffett. He compares the total value of the stock market to our country’s GDP to measure the market’s overvaluation or undervaluation. Right now, the market value is 40% larger than GDP, which hasn’t happened since 1999.
Comparing these metrics to those sported by foreign markets can be tricky. Frankly, the year ahead brings ample uncertainty about 2015 earnings growth outside the United States, as depressed commodity prices dampen earnings, Europe wrestles with the forces of deflation and China engineers an economic soft landing. Generally speaking, though, most foreign markets sport forward P/E ratios in the 10-to-15 range.
The trigger for fund flows away from our markets and back to other markets might be a rebound in commodity prices, signs that European economic activity is strengthening, a boost from China (which is now saving billions of dollars thanks to falling oil prices) or simply a decision by major global investors to shift away from the aforementioned “Flight to Quality” mentality.
Looking for a near-term catalyst? The expected mid-year start on interest rate increases. A study performed by Barclay’s found that “international stocks have outperformed the U.S. market by almost four percentage points in the six months after U.S. rate hikes.” This happens because rising rates tend to modestly slow an economy’s momentum and on a relative basis, foreign stocks won’t face the same headwind.
In fact, the recent plunge in oil prices will enable many foreign central banks to ease up on inflation concerns, leading to a drop in interest rates. I recently outlined such a scenario in Turkey. Interest rates appear poised to drop in Asia and other emerging market regions as well in 2015.
Risks To Consider: Selectivity is key. Some foreign markets will fare a lot better than others in 2015. It’s crucial to understand the dynamic economic cross-currents in play before committing to any foreign market. And when you do decide to invest in a foreign company, market or region, you need to have longer-term time horizon, simply due to the inherent volatility of foreign markets.
Action To Take –> By almost every measure, the U.S. appears to be a wiser destination for investors. The country’s economy is growing at a better-than-expected rate, and clear headwinds remain in place elsewhere. Yet the logic behind that move has already led to robust returns here in the United States and dampened returns elsewhere. The key is to look ahead, not behind and focus on the best relative values. Right now, many of them reside outside our borders.
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