Roam If You Want To

by: Eric Parnell, CFA


U.S. stocks have performed tremendously well since the calming of the financial crisis several years ago.

The same cannot be said of their stock brethren across the rest of the world.

Those that are bullish may be interested to roam around the world to capitalize on what may be relatively attractive valuations and upside returns opportunities.

U.S. stocks have performed tremendously well since the calming of the financial crisis several years ago. But the same cannot be said of their stock brethren across the rest of the world. Now some like myself may look amid a sluggish global growth environment at the relatively rich valuations and wide performance disparity of U.S. stocks versus those outside of the U.S. and take the bearish view that U.S. stocks are at risk of catching down to the rest of the world. But suppose you are of a more bullish persuasion. Suppose you believe that the U.S. stock market is actually the one that has it right while the rest of the world is wrong and that sustained economic growth as well as a strong corporate earnings resurgence is right around the corner. If this is the case, then you may be interested to roam around the world to capitalize on what may be relatively attractive valuations and upside returns opportunities. But don't forget your tickets and your risk management tools before taking such a trip.


The outperformance of the U.S. stock market relative to the rest of the world has been extraordinary in recent years. In the early years of the post crisis period, U.S. stocks as measured by the S&P 500 Index (NYSEARCA:SPY), developed international stocks as measured by the MSCI EAFE Index (NYSEARCA:EFA), and emerging market stocks as measured by the MSCI Emerging Markets Index (NYSEARCA:EEM) all moved generally in lockstep with one another.

The first to fall off the pace were developed international stocks, as increasing pressure on the eurozone experiment that has included crises in countries like Spain (NYSEARCA:EWP), Italy (NYSEARCA:EWI), Portugal (NYSEARCA:PGAL) and Greece (NYSEARCA:GREK) along with ongoing growth challenges in Japan (NYSEARCA:EWJ) had the EAFE Index falling off the pace as early as 2010, effectively grinding sideways ever since.

Emerging market stocks faded off the pace not long after in 2011, as China's (NYSEARCA:ASHR) slowing economy coupled with increasing economic challenges for the many commodities exporters that sell to China (NYSEARCA:GXC) including Brazil (NYSEARCA:EWZ) and Russia (NYSEARCA:RSX) left this market going effectively nowhere other than sideways more than five years now.

The result of this vast performance disparity that continues to this day is the following. U.S. stocks as measured by the S&P 500 Index are trading at an incredibly lofty 25.2 times trailing 12-month earnings. This ranks among its highest historical valuations, only surpassed by the years surrounding the technology bubble back around the turn of the millennium. By comparison, developed international stocks as measured by the MSCI EAFE Index are trading at a far more reasonable 15.7 times earnings, while emerging market stocks as measured by the MSCI Emerging Markets Index are trading at an even cheaper 11.3 times earnings.

It should be expected that the U.S. market will trade at a premium to developed non-U.S. and emerging market stocks at any given point in time given the relative safety implied by investing in what is by far the largest, most developed and well established stock market in the world. But this much of a premium is considered highly unusual.

I am not a believer in the notion of decoupling when it comes to stock markets around the world. If we learned anything from the financial crisis a decade ago, it is that we live in a globalized world with a deeply interconnected financial system. Going back even further in time, history has also shown us that when a butterfly flapped its wings in Thailand through a currency devaluation, we eventually had a hurricane here in the United States in the form of the collapse of Long-Term Capital Management. It didn't happen overnight, mind you, but took months if not years to fully play itself out. Thus, if global markets diverge widely at any given point in time, they will eventually find their way back to converging in one way or another, and no amount of nationalist sentiment on the current global political scene is going to change this reality any time soon.

The Optimistic View

Accepting the fact that we continue to operate in an intertwined globalized financial system and that markets will eventually recouple at some point, it is worthwhile to consider the optimistic view. If U.S. stocks are indeed so far ahead of the rest of the world, what exactly does the rest of the world have to offer that may be of interest to value-oriented, long-term investors?

The first element that must be considered when exploring the world in the current market environment is the key risk factors. And currency risk is critically importance to manage against at the present time. Shifts in currency exchange rates can be one of the largest if not the primary driver of returns performance for international investors at any given point in time. And as global central banks continue to thrash and struggle to revive economic growth amid rising geopolitical uncertainty, currency volatility has been rising. This includes shifts in currency exchange rates between developed economies that might historically take place over the course of a year or more in a more stable economic environment playing out over the course of a day or less in certain circumstances. Needless to say, a sudden -15% drop in the value of the British pound (NYSEARCA:FXB) or a +40% appreciation of the Swiss franc (NYSEARCA:FXF), both relative to the U.S. dollar (NYSEARCA:UUP), while you are sleeping one night can wreak havoc on the performance of your related portfolio stock holdings at any given point in time.

Careful consideration must be given as to whether any non-U.S. stock exposure should be currency hedged at any given point in time. Now the natural first instinct is to hedge the currency risk if the option is available. In short, no currency risk, one less thing to worry about the thinking may go. After all, nothing is more frustrating than to get your regional stock market call correct but have your returns wiped away by the vagaries of currency exchange. But this conclusion unfortunately oversimplifies the discussion.

A point that many people forget is that risk is a double-edged sword. It is something to guard against to the downside, but it is also something to capitalize on to the upside. For example, suppose it is the spring of 2015 and we have just gone through a period of sharp U.S. dollar strengthening relative to global currencies. If the U.S. dollar is running hot relative to global currencies, it may actually benefit you to undertake an unhedged currency exposure instead. For in some instances, a rebound in currency exchange rates relative to the U.S. dollar might be the saving grace for a regional allocation that might have otherwise generated a negative return.

As a result, whether to select a currency hedged or currency unhedged non-U.S. investment option needs to be determined on a case-by-case basis at any given point in time. My preference from a risk management perspective is to opt for a currency hedged option if it is available unless a have a particularly strong view on the currencies themselves or if including the currency risk provides added diversification and risk management benefits to the broader asset allocation for an investment portfolio.

Before going any further, it should be noted once again that I am bearish and more of the pessimistic view. As a result, the following should not be viewed as buy recommendations but instead possibilities for consideration for those that may have a more optimistic view on the global economy and its financial markets. I do own some of the choices listed below and am considering selected others, but there are a number that I do not own and do not intend to pursue as well given my more bearish view. But those that are more bullish may see opportunities.

Roam Around The World

With all of this in mind, let's roam around the world. For the purposes of discussion let us first consider expected economic growth for the coming year based on forecasts from the July 2016 World Economic Outlook Update. The following are year-over-year projections for the percentage change in output in 2017 for selected economies and regions around the world.

United States +2.5%

Euro Area +1.4%

Germany +1.2%

Japan +0.1%

United Kingdom +1.3%

Canada +2.1%

Emerging Markets +4.6%

The quick summary is the following. Economic growth is expected to be positive for 2017, but sluggish. The United States is expected to grow marginally faster than the rest of the world, while Japan is projected to be the growth laggard. And Emerging markets are still expected to grow faster than developed economies. In short, not a whole lot new here versus what we have seen in 2014 through 2016. Moreover, it is important to note that these remain estimates and are subject to revision including downward adjustments to current forecasts.

Another arguably more important point from an investment perspective is also worth mentioning. Global central bankers remain biased toward aggressive stimulus and remain super accommodative despite whatever they might say to the contrary. For example, the Bank of Japan's Kuroda ruled out the idea of using 'helicopter money' during a recent radio interview, which from my perspective means that we are still likely to see 'helicopter money' sometime in the next several months. After all, what's a good monetary stimulus program without the element of surprise at its announcement, right? Thus, recognizing that the ongoing monetary stimulus from global central banks have the potential more than overwhelm economic forces on the markets at any given point in time should be accepted in advance as a given.


Developed International

Let's begin our trip with a broad view of developed international markets as measured by the MSCI EAFE Index. These collective markets have a price-to-earnings ratio of 15.7 times trailing earnings, which is a bit rich in its own right but still compares favorably to that of the U.S. Both currency hedged and currency unhedged (BATS:HEFA) options are also available, with the hedged option offering slightly less price volatility versus the S&P 500 Index with a beta of 0.97 versus the unhedged option that has a beta of 1.11. And while the currency hedged offering got a bit ahead of itself following the strong surge of the U.S. dollar into 2015, much of these effects have since been neutralized.


A segment of the developed world that may be of particular interest to investors is the eurozone, which has trailed U.S. stock performance widely in recent years. At present, eurozone stocks are trading at 15.1 times trailing earnings, which also compares favorably to the U.S. However, investing in Europe does come with its specific risks at the present time. Not only is price volatility marginally higher with a beta of 1.19 on the unhedged offering (BATS:EZU) and 1.12 on the hedged product (NYSEARCA:HEDJ), but the risk of an economic shock looms large given the European Union's ongoing structural challenges and rising nationalist sentiment on the political front. Given the potential pass through effects from these challenges on the euro currency coupled with the ECB's insistence on continuing to do "whatever it takes" suggests that opting for the currency hedged option here would be the better selection from a risk control standpoint in most cases.

Emerging Markets

Moving on to the more speculative area of emerging markets, this would be a portfolio allocation that should be considered much more carefully from an economic growth and geopolitical risk standpoint. For example, the ongoing evolution of Russia, the economic challenges and sweeping political changes in Brazil, the widespread uncertainty about the true state of China (NYSEARCA:FXI) and the recently surprising events in Turkey (NYSEARCA:TUR) all highlight the additional risk factors that accompany investing in emerging markets. Just like with its developed counterparts, both currency unhedged and currency hedged (NYSEARCA:DBEM) offerings are available. And while opting for the currency hedged option would take one more risk factor off the table in isolation, the case can be made for opting for the currency unhedged choice when incorporating such an allocation into a broader portfolio given the added diversification benefit provided by the shifts in the various currencies that make up emerging markets.

Individual Countries

Beyond regional allocations, investors may also wish to allocate to specific countries where they have a particularly strong view. Given all of the uncertainty that continues to persist in the current market environment, it is recommended at the outset when investing in individual countries to stick with the well-known and established larger markets and lean away from the more specialized and developing ones. As a most recent example, an individual investor is likely best served avoiding making a heavy direct bet to a market like Turkey right now unless they have particularly good-on-the-ground insights as to what is happening there right now. It is also worthwhile to stick with the more established markets because currency hedged alternatives are also available for consideration as an alternative.


The world's third largest economy is well into its third decade of trying to escape from the deflationary growth trap it first tumbled into back in the early 1990s. But the current leadership has also been operating with full monetary guns blazing since taking control in early 2013. And after having their economic mandate reinforced following their recent elections, even more aggressive stimulus is expected from the Bank of Japan in the coming months. Such is the case for the currency hedged (NYSEARCA:DXJ) option over its currency unhedged alternative.


If one is going to invest in the eurozone, it is understandable to wish to focus on what is the largest and most stable economy in the region while leaving out the rest. Germany is currently trading at 14.6 times earnings, which is most favorable relative to its developed market counterpart in the U.S. Of course, Germany is also at the epicenter of what remains an evolving challenge in keeping the European Union together. Moreover, German stocks have been trading with meaningfully greater price volatility as of late with a beta of 1.42 for the unhedged option (NYSEARCA:EWG) and 1.35 for the hedged alternative (NYSEARCA:HEWG). Just like with the broader eurozone allocation, the better bet would be to opt for the hedged allocation given the uncertainties overhanging the euro currency.

United Kingdom

Here we see the advantages of a currency hedged option during periods of event uncertainty. In the wake of the much ballyhooed 'Brexit' vote, U.K. stocks have soared to the upside. But at the same time, the British pound has been obliterated. Thus, those with a U.K. currency hedged allocation (NYSEARCA:HEWU) are higher by nearly +6% since 'Brexit', while the unhedged option (NYSEARCA:EWU) is down more than -6%. Such currency risk cuts both ways, but in this instance it cut in favor of those with the hedge. Moreover, in the case of the U.K., the currency hedged option has traded with a much lower beta of 0.61 versus the unhedged option at 1.02. With that said, the United Kingdom is one of the few markets around the world that is arguably just as expensive if not more so than the United States with its P/E ratio at 20 times trailing earnings.


Staying in Europe, one more high quality market worth consideration is Switzerland. It is also rich from a valuation perspective at roughly 19 times trailing earnings, but it has moved largely in lockstep with U.S. stocks on an unhedged basis (NYSEARCA:EWL) since the outbreak of the financial crisis so many years ago. This is also an example of a market where the currency hedge has been a drag on returns, as the Swiss franc has had its periods of strength amid the uncertainties overhanging the eurozone. And while it is expensive, it is notable for its low betas of 0.92 unhedged and 0.77 hedged (NYSEARCA:HEWL) relative to the S&P 500 Index.


Suppose you are more inclined toward the major developed economies with a heavy commodities bent. Canada with its 33% weighting to the energy and materials sector is one such market. It has endured its challenges in recent years amid the oil price collapse, but in the process is trading at a relatively less expensive 16.1 times earnings. And much like Switzerland, owning Canada has come with relatively less price volatility with betas of 0.86 for the unhedged offering (NYSEARCA:EWC) and just 0.53 for the hedged alternative (NYSEARCA:HEWC).


Another major developed commodities producer closer to China is Australia. More diversified than its North American counterpart with a 17% weighting to energy and materials, Australia is a country that has fallen off the pace only more recently amid the sharp decline in oil and commodities prices. As a result, it is trading at a more reasonable 15.8 times trailing earnings. And while the currency hedge served as drag during a good portion of the post-crisis period, this differential has since been neutralized. In addition, the currency hedged (NYSEARCA:HAUD) option offers lower price volatility with a beta at 0.82 versus a beta of 1.32 for its unhedged counterpart (NYSEARCA:EWA).

The Bottom Line

Whether you're an outright bull or you simply want to find ways to be bullish, the rich valuations that come with the U.S. stock market are becoming an increasingly challenging pill to swallow. But given the performance disparity in recent years between the U.S. and the rest of the world, a variety of relative value opportunities exists that may be of interest to risk-prone investors. Such non-U.S. allocations come with additional risks that may be elevated even further in the current market environment, but a careful risk management approach can enable investors to position for these opportunities if they view them to be desirable while still keeping a close rein on risk control.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I am/we are long DXJ.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.