Picking the best stocks in an asset class is important, but selecting the right asset classes at the right time can be even more crucial.
International stocks have underperformed US stocks by a wide margin in the past decade.
There is a massive valuation gap favoring international stocks right now.
The momentum indicators are pointing towards international stocks.
Selecting the best stocks in a particular asset class is very important, no doubt about that. However, it's easy to miss the forest for the trees when making investment decisions, and selecting the right asset classes at the right time can be even more crucial.
When a particular sector of the market is booming, even a mediocre company in such a sector can deliver generous gains. On the other hand, when an asset class is collapsing, chances are that most individual stocks in such an asset class will also suffer heavy losses.
International stocks, both in emerging markets and developed markets, have significantly underperformed U.S. stocks over the past decade. This has produced a massive valuation gap, and international stocks are now massively undervalued in comparison to U.S. markets.
Not only that, but global stock markets are displaying vigorous momentum lately, and the quantitative momentum metrics are saying that international stocks look like a strong bet going forward.
International Markets Look Undervalued
The U.S. economy has performed relatively better than other countries over the past decade, and many of the most successful and profitable global corporations in the world are listed in the U.S. stock market.
In this context, it's easy to understand why US stocks have done much better than international stocks over the past decade. The chart below compares the performance of SPDR S&P 500 (SPY) versus iShares MSCI EAFE ETF (EFA) and iShares MSCI Emerging Markets ETF (EEM) in the past ten years.
The performance gap is quite staggering, with the U.S. market more than tripling international markets on a cumulative return basis in the past decade.
But past performance does not guarantee future returns. In fact, valuations many times revert to the mean. The entry price can have a huge impact on subsequent returns, and international stocks are trading at a massive discount versus U.S. stocks nowadays.
The chart compares the evolution of the cyclically adjusted price to earnings - CAPE - ratio for US stocks versus international stocks. The valuation gap is at its widest level in the past 40 years.
Source: Meb Faber Research
It is not just about the CAPE ratio, all kinds of valuation metrics are telling a similar story. The table shows forward PE, price to book value, price to sales, price to cash flow, and dividend yield for SPDR S&P 500 in comparison to iShares MSCI EAFE ETF and iShares MSCI Emerging Markets ETF.
The main takeaway is quite clear, international stocks are much cheaper than US stocks, no matter what valuation metric you look at.
|Dividend Yield %||2.1||3.42||3.15|
Valuation is not the only return driver for stocks, that goes without saying. There are all kinds of economic and political variables to consider when trying to evaluate the potential for risk and return in a particular asset class going forward.
However, the fact remains that valuation is one of the main return drivers to consider over the long term. The chart shows the relationship between CAPE ratios and subsequent returns for different markets over the long term.
Source: Star Capital
Importantly, valuation also has big implications in terms of downside risk. The higher the CAPE ratio, the bigger the maximum drawdown in the following years.
Source: Star Capital
Future returns will depend on a multiplicity of factors, many of them unpredictable and even unknown. Nevertheless, the lower the valuation, the higher the potential returns and the lower the risk of big losses. This is a major argument for international stocks in the years ahead.
The Momentum Indicators Are Pointing Towards International Stocks
Valuation is a key driver of return and risk over the long term, but it's not a timing tool. If you want to identify the best entry times in different asset classes, price behavior in terms of momentum and relative strength is much more relevant.
The Asset Class Rotation Strategy is a quantitative system that is available in real time for members in The Data Driven Investor. This system rotates between 9 ETFs that represent some key asset classes.
- SPDR S&P 500 (SPY) for big stocks in the U.S.
- iShares Russell 2000 Index Fund (IWM) for small U.S. stocks
- iShares MSCI EAFE (EFA) for international stocks in developed markets
- iShares MSCI Emerging Markets (EEM) for international stocks in emerging markets.
- Invesco DB Commodity Index Tracking (DBC) for a basket of commodities
- SPDR Gold Trust (GLD) for gold
- Vanguard Real Estate ETF (VNQ) for REITs
- iShares 20+ Year Treasury Bond (TLT) for long-term treasury bonds
- iShares 1-3 Year Treasury Bond (SHY) for short-term Treasury bonds
In order to be eligible, an ETF has to be in an uptrend, meaning that the current market price is above the 10-month moving average. If no ETF is in an uptrend, the system goes for the safest asset in the group, which is iShares 1-3 Year Treasury Bond.
Among the ETFs that are in an uptrend, the system buys the top 3 with the highest relative strength. Relative strength is measured by a ranking system that considers total returns over 3 months and 6 months, and it includes volatility as a negative factor.
The ETF portfolio is rebalanced monthly, and the benchmark is a globally diversified portfolio that is allocated 60% to stocks and 40% to fixed income.
Backtested performance numbers are quite strong. Since January of 2007, the strategy gained a cumulative 313.7% versus 88.4% for the benchmark. Annual return is 12.4% for the strategy versus 5.3% for the benchmark over that period.
Not only that, the Asset Class Rotation strategy has a maximum drawdown of 14.4% versus 35.4% for the benchmark. Maximum drawdown is calculated as the greatest percentage drop from the high based on daily closing prices.
Even if we use the SPDR S&P 500 as a benchmark, the system still outperforms by a wide margin in terms of both returns and downside risk. This is saying a lot, because the S&P 500 has performed exceptionally well in recent years.
The Asset Class Rotation strategy basically buys strength and sells weakness. For this reason, the strategy was mostly positioned in safe-haven assets such as Treasures, gold, and cash during the financial crisis in 2008. This can make a big difference in terms of providing capital protection in a tough market environment.
On the other hand, it takes time for the strategy to adapt to incoming information. The portfolio was positioned for safety in January of 2019 - mostly due to big market pullbacks in the last quarter of 2018. Since stocks rapidly reversed higher in January, the strategy underperformed the benchmark in the first couple of months in 2019.
That is just the nature of the game with these kinds of quantitative models. Risk-adjusted returns tend to be very attractive over the long term, and particularly in times when there are well-defined trends in different asset classes. However, in times of sideways price action in the markets, a quantitative strategy such as this one should be expected to deliver disappointing performance.
Going back to the main thesis for international stocks, the three leading ETFs in the relative strength ranking system are currently SPDR Gold Trust, iShares MSCI EAFE ETF, and iShares MSCI Emerging Markets ETF.
Gold, developed market stocks, and emerging markets stocks are leading other asset classes in terms of relative volatility-adjusted performance. Not only are international stocks much cheaper than US stocks, but global markets are also starting to show superior relative strength lately.
The Bottom Line
Value and momentum are arguably the two most important return drivers to consider. You want to buy cheap stocks, and you also want to buy those cheap stocks at the right time, meaning when they are starting to outperform.
Considering both the size of the valuation gap and the main trends in momentum over the middle term, it makes a lot of sense to expect international stocks to deliver attractive performance going forward.
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.