- Kyle Johnston
What is the Benefit of Investing in International Stocks?
From the end of 2009 through 4/30/23, U.S. large cap stocks (as defined by the S&P 500 Index) returned 12.59% annually while developed international stocks (MSCI EAFE Index) returned just 5.16% annually and emerging markets stocks (MSCI EM Index) returned 2.33%. The post-Great Financial Crisis (GFC) era has punished investors who diversified their stock portfolios on a geographic basis. The dominance of U.S. technology and social media stocks propelled the S&P to higher and higher levels while international markets floundered. After such a stretch of dominance, American-based investors may wonder if it is worth having international stocks in their portfolio. After all, they earn and consume in the U.S., the U.S. continues to have many of the world's largest and most dominant firms, and the U.S. has consistently outperformed the rest of the world for many years. Despite these points, the argument for having exposure to international stocks may be compelling.
(1) Cycles of Outperformance:
U.S. and international markets often go through prolonged, multi-year cycles of relative under/outperformance. According to analysis by JP Morgan in their quarterly "Guide to the Markets", the U.S. market has just ended a 14.2 year cycle of outperformance*, the longest on history when looking back to 1971. Prior to the record stretch of U.S. dominance, cycles had lasted anywhere from 1.4 years to 7.2 years, with the average being just over 4 years. The EAFE index is now in a stretch of outperformance of 1.3 years through 3/31/23, and counting. Markets may quickly revert to U.S. dominance, but after such a long stretch of U.S. outperformance, it is worth allocating to international markets in the event that we are in a new cycle of relative returns. Mean reversion is one of the strongest forces in the markets.
*JP Morgan recognizes an end to a cycle of outperformance when cumulative outperformance peaks and is not reached again over the subsequent 12 months
Diversifying geographically can also help mitigate the risk of a lost decade of stock market returns. During the 2000's, U.S. large cap stocks experienced one of these lost decades. From 12/31/2000 to 12/31/2010, the S&P 500 returned just 1.41% annually vs. returns of 3.50% annually for international developed and 15.87% annually for emerging markets.
Data from YCharts
(2) Relative Valuations:
During the record stretch of outperformance, U.S. markets have become increasingly more expensive relative to all international stocks (MSCI All Country World Ex USA Index) on a price per dollar of earnings basis. At the start of the period, international stocks were priced at very similar levels to the U.S. market, but as of 4/30/23, they now trade at a 29.5% discount*. At the end of March, the S&P 500 sat at a price of 17.8 times estimated earnings over the next 12 months (the 20-year average is 15.5x) while the international index was priced at 12.6 times (the 20-year average is 13.1x)*. In addition, the ACWI ex USA Index is paying a dividend yield that is close to 1 point higher than the S&P 500, at 2.45% vs. 1.55%.
*Data from JP Morgan Guide to the Markets
(3) Drivers of Return:
Stock returns are driven by a combination of dividends, earnings growth, and changes in valuation multiples (i.e. the price investors are willing to pay for the future cash flow streams of the basket of stocks). As detailed in the prior bullet point, a good portion of the outperformance of U.S. stocks can be attributed to their change in valuation multiple relative to their international peers. From 2010 to 2022, the forward price to earnings multiple on the S&P 500 rose from around 13-14x to close to 18x as investors became willing to pay higher and higher prices for this basket of companies. While the S&P did experience a higher rate of earnings growth than international developed stocks (EAFE) (earnings growth), the expansion in multiple, both absolute and relative to the EAFE, was a large contributor that is unlikely to continue given the magnitude of the current valuation gap. As it stands now, international stocks appear to have two of the three main return drivers in their favor; dividends and relative valuation change.
International stocks tend to do better as the U.S. Dollar becomes relatively cheaper to other currencies. The U.S. Dollar weakened from the early 2000's to the early 2010's and strengthened from the early 2010's to present. Unsurprisingly, this pattern lines up closely to the relative performance cycles of U.S. and international stocks. In this sense, having sufficient exposure to international stocks can be somewhat of a hedge against a decline in the relative value of the U.S. Dollar and its impact on U.S. stocks.
(5) Sector Makeup:
The composition of the S&P 500 and the EAFE is substantially different. Some of the largest differentials are as follows: 26% of the S&P is in technology stocks vs. 8% of the EAFE, 16% of the EAFE is in Industrials vs. 8% of the S&P, 18% of the EAFE is in financial services vs. 13% of the S&P, and 7% of the EAFE is in basic materials vs. 2% of the S&P. Overall, the EAFE is 39% comprised of economically cyclical stocks vs. 28% for the S&P. Over the last 10+ years, technology stocks like Apple and Microsoft have crushed other areas of the markets. Given the much larger weighting to this sector, technology stock returns have been a massive tailwind to the S&P 500. On the other hand, financials have struggled in the post-GFC era as rates have stayed low and banks have struggled to expand their net interest margin (the difference between the money they earn on making loans and the money they pay out to depositors). Given the much larger weighting in the EAFE, this has been a headwind for developed international stock returns. Below are pie chart comparisons of the sector breakdown based on data from Morningstar:
To wrap it up, U.S. large caps stocks have long benefitted from tailwinds in valuation expansion, currency appreciation, and index composition. Given the cyclicality of relative performance cycles, wide gaps in relative valuation levels, and the end of an extended era of U.S. outperformance, now is a good time to evaluate your exposure to international stocks. Country and regional stock markets can go through lost decades of paltry returns and being diversified geographically can mitigate the pain felt in such times. While diversification benefits may not be felt in sharp down markets and market crises, allocating to international developed stocks and emerging markets stocks may help mitigate the risk of a lost decade in U.S. large cap stock returns.