September 21st, 2018 | by Gregg S. Fisher, CFA, "Invest with Reason"
Should Investors Exit International Stocks?
• Foreign stocks have trailed badly behind US stocks so far in 2018, leading some investors to question whether they should maintain foreign exposure in their portfolios.
• US and foreign stocks move in somewhat different cycles, which are difficult to predict.
• Over most extended investment time horizons, a global portfolio outperforms a US-only portfolio on a risk-adjusted return basis.
We believe that a change in market climate in 2018 has weighed on foreign stocks. The escalating trade war between the US and China, the world’s two largest economies, has created uncertainty. The US dollar, after weakening throughout 2017 and into January of this year, has surged nearly 7% in value (as measured by the Dollar Index Spot) since February 1, 2018, perhaps due to rising US interest rates and stronger economic growth. Currencies of developing countries with large quantities of US dollar-denominated debt (including Turkey, Argentina, and Indonesia) have suffered sharp declines in value.
Result: Year-to-date through September 17, while US stocks (S&P 500 Index) gained 9.6%, the MSCI EAFE Index of foreign-developed countries fell 2.7% and emerging markets (MSCI EM Index) slumped 10.4%. Since many investors are questioning their portfolios’ foreign-stock exposure, I thought now was an opportune time to conduct a bit of research into the merits of maintaining a global (instead of US-centric) equity portfolio.
Past and Future
An investor who flits from foreign to US stocks now due to the recent performance gap is acting on what we call recency bias in behavioral finance, or a tendency to make decisions by looking through the rear-view mirror. The US market certainly looks strong now, but extrapolating past events and patterns into the future is always a risky game. For one thing, equity valuations in the US are quite high both on a relative (e.g., the S&P 500 Index’s price-to-book ratio of 3.5 is more than double that of foreign markets) and on a US-historic basis, which implies lower returns moving forward. Besides, it’s a big world out there: The US accounts for one-half of the world’s stock market capitalization, but less than a quarter of global GDP, about 10% of globally listed securities, and less than 5% of the world’s population.
The economy and corporate earnings appear robust in the US right now, but domestic equities may have already discounted this current strength. I make no predictions, but I do note that the US environment is not without risks for the market. For instance, interest rates are rising and the yield curve has dramatically flattened, which is often a precursor to slower economic growth. This year’s boost to earnings and economic expansion from the sharp tax cuts will likely start to fade in 2019; the federal budget deficit has ballooned this year, despite strong economic expansion, and is projected by the Congressional Budget Office to reach $1 trillion in 2019. When it comes to tariffs and protectionism, I doubt any economist has a crystal ball for determining the exact implications of rising trade tensions for US growth, employment, or earnings.
Apart from the current issues of valuations and risks in the US, I think it makes eminent sense to maintain a healthy weighting in foreign stocks (for instance, a 30% to 35% allocation) in a globally diversified equity strategy. As with currency movements and growth vs. value and small vs. large caps in stocks, US and foreign equities tend to move in somewhat different cycles. Since we discourage attempts at market timing and cannot predict when a cycle will begin or end, we think long-term investors are wise to hedge bets by adhering to a globally diversified portfolio.
The Global Portfolio
Exhibit 1 compares the performance of US, international, and global portfolios from 1970 to this year. Interestingly, even though US stocks outperformed foreign ones in terms of both return and volatility, the global portfolio still achieved the highest return with the lowest volatility (i.e., the highest Sharpe Ratio). This 2+2>4 result speaks to the benefits of combining asset classes with less-than-perfect correlations in a diversified portfolio.
Of course, few of us are able to invest over a 49-year timeframe. Therefore, we also compared performance using 10-year rolling returns, a statistically robust method in which moved 10-year periods forward a month at a time across the entire 1970 to 2018 time horizon. We found that the same global portfolio, as defined in the exhibit above, outperformed the US-only one in 61% of 10-year time periods, while the US portfolio held the upper hand in 39% of cases. Exhibit 2 graphs the returns of these two portfolios. Exhibit 3 traces the “global premium,” which may be defined as the excess return of the global portfolio as compared to US-only. As you can see, the “premium” has actually been negative in recent years.
In sum, I would advise against jettisoning foreign stocks simply because they have recently trailed US securities performance. Overseas exposure is an important component of portfolio risk management and, as our study shows, tends to reward long-term investors.