Be Contrarian And Invest In Foreign Equities

Includes: EEM, IEUS, SMLF
by: Jussi Askola


The US financial market seems to be the place to be today for foreign investors.

Foreign capital inflow affects the US asset prices and lower expected returns.

Foreign investors invest massively in the US due to its perception as a safe heaven.

Be contrarian and do the opposite – Don’t follow the crowd.

Now before I start presenting this thesis, please note that I am not saying you should only buy international securities. You definitely should own US securities, but remark that other international markets are likely to be undervalued relative to the US as a function of the large foreign cash inflow to the US market. With the current issues and uncertainties around the world, the US has gained the perception of a "safe harbor" and as a result attracted massive amounts of capital from many foreign countries.

Foreign investors own today 20% of US stocks, 43% of US bonds

What is the direct consequence of this excess demand for US securities? Their prices get bid up higher and result in lower expected future returns. The more money flows in the US and the bigger the asset bubble will become. There is plenty of evidence that this foreign capital has had a large effect on today's valuation of American equities and bonds. Just look at how the fed is unable to increase its rates because otherwise the demand for the long term US treasuries would be so high that the curve would quickly become inverted. The USA still has some of the highest yields worldwide and it is almost impossible for the fed to materially increases rates as long as other economies keep them so low. I come from Europe and I can tell you that with the current negative interest rates that we have over here, lots of investors are very tempted to invest in US bonds, creating more demand and bringing US yields even lower. Foreigners own today almost half of US bonds, and without this demand, the fixed income bubble would likely be smaller and expected returns higher.

In the equity market, similar evidence exists. One great example is the impact that the Chinese stock market had on the US financial market. The capital outflow from China to other financial markets was so large that it contributed to a bid up of earning multiples in other countries including the US. A bad year in China contributed to a good year in the US equity market. I do not consider this to be rational considering that China used to represent half of global growth. It increases the evidence that the US equity market is likely to be currently overvalued and the Chinese market undervalued.

SPY Chart

SPY data by YCharts

Another more recent example was Brexit. On June 23rd 2016, the United Kingdom voted to leave the European Union and as an immediate consequence, the stock market crashed as many investors sold off all their UK securities with the intention of leaving the UK and reallocating the capital into a "safe harbor". Now what I don't get is what sense does it make to sell right after a crash in order to reallocate the capital into another market such as the USA trading at all-time highs. We are all taught to act in the opposite way, but that is exactly what happened. Today, UK capital is pouring to the US day after day and keep biding up the valuations to even more unsustainable levels.

In consequence, US bonds are expensive, but still reasonably priced relative to other international markets. However, the US stocks are today very expensive on both absolute and relative basis.

US stocks have expected returns of about 4% and asymmetric risk on the downside

While bonds are extremely overvalued, you could argue that stocks present a better alternative at current valuations. I would agree on that one, however remark that stocks are also very expensive relative to its historical average valuations. Its P/E multiple is today way beyond its average. The market is currently pricing the S&P500 at over 25 times its earnings. The historical mean being only 15.6 times or 40% cheaper than today.

Source: multipl

You will note that historically every single time the P/E ratio passed 25, it was later followed by a crash in the market. Ray Dalio, founder and co-chief investment officer of the world's largest hedge fund, Bridgewater Associates, believes that the expected returns for US stocks is about 4% at current high valuations and that volatility will be above average.

Get ready for lower than normal returns with greater than normal risk. Take current bond yield (less than 2%) and cash (0%) and compare that to something like a 4% expected return on equities. Because of volatility, the 4% expected annual return pick up of equities over cash, or 2% over bonds, can be lost in a day or two.

The fundamentals of the global economy are not very strong, earnings are flattening in the US, we risk a new recession, a potential new stock market crash and the expected returns of the US stocks do not compensate for the risk undertaken at current high valuations. If you are going to take equity risk today, at least get compensated for it with lower valuations than reflected the real economic state of the world.

Don't get me wrong, I am very long on US stocks, but I am just trying to point out that the risk/reward ratio of US stocks is not necessarily any better than the one of foreign equities today.

Foreign Equities: the contrarian alternative…

Foreign equities seem to have become one of the most contrarian of all asset classes today. Everybody wants to be invested in the US due to the slowdown in emerging markets and the uncertainties in Europe and Japan. People are getting more and more greedy on US stocks and you know the consequences: they get bid up and trade today at dangerous levels that are not justified by superior economics; opposite of that earnings seem to be at best flattening. This valuation does not reflect the reality and is artificially high partly due to this high foreign demand.

Foreign equities suffer today the opposite issue. Since investors are selling their European and Emerging market equities to reallocate to the US, they are likely to be undervalued relative to the US. The cash outflow has been so strong that in many cases their valuations are getting attractive even on an absolute basis.

Today the MSCI Europe Small Cap (NASDAQ:IEUS) trades at 19 times its earnings and only 15 times its next year's earnings. To put that into perspective, the MSCI USA Small Cap (NYSEARCA:SMLF) trades today at 36 times its earnings.

The MSCI Europe Large Cap trade at about the same the same multiple as the small caps namely 20 trailing earnings and the MSCI Emerging Market (NYSEARCA:EEM) seem to provide great value today trading at only 13.8 times earnings.

In comparison, the MSCI USA Small Cap trades today at 36 times its earnings and the S&P at more than 25 times its earnings. Now I am not saying that the European and Emerging market equities should be trading at the same multiples as the US stocks; to some extent, the American equities deserve to trade at higher valuations, but is such a large difference justified?

The investors that tend to outperform are the ones who move in the opposite direction of the crowd and buy assets when they offered at cheaper prices. In this case, perhaps investing in Europe could make sense when so much European money is getting transfered to the US. The US bull stock market has been abnormally long and asset prices are today getting expensive on a relative basis. I have no idea when the next bear market will start but at today's prices, the expected return do not seem to compensate investors for the risk undertaken. In my view, based on today's lower valuations, the European market provides higher expected returns and/or less downside risk.

Final Thoughts

Stay invested in the US market at all time, but not fully. When asset prices get very high and expected returns low, there is nothing wrong with allocating a larger portion in other cheaper assets including foreign stocks. In today's market environment, foreign equities have many positive attribute and are becoming more competitive with US stocks.

Be contrarian and invest outside of the US.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.