International stocks have widely underperformed U.S. stocks in the past decade.
At current prices, international markets are deeply undervalued versus U.S. markets.
Relative momentum trends are starting to favor international stocks.
We want to buy cheap markets, and we also want to buy them when they are starting to outperform.
Both value and momentum are favoring a sizable allocation towards international stocks right now.
Buying the best stocks in a particular market is very important, and it can make a big difference over the long term. However, it's easy to miss the forest for the trees when making investment decisions, and selecting the right markets at the right time can be even more crucial.
When a particular market is booming, even a mediocre company in such a market can deliver generous gains. Like Warren Buffett said: "A rising tide lifts all boats". On the other hand, when a particular market is struggling, chances are that a large percentage of the stocks in such a market will tend to deliver disappointing returns, even the ones with strong fundamentals.
International stocks, both in emerging markets and developed markets, have significantly underperformed U.S. stocks over the past decade. This has produced a wide valuation difference, and international stocks are now massively cheaper than U.S. stocks.
Interestingly, the main trends seem to be reversing lately, with international stocks starting to produce better returns in recent months. In terms of both value and timing, it makes a lot of sense to consider a sizeable exposure to international stocks in the current environment.
International Stocks Are Massively Cheaper
Stock market returns are not only driven by fundamentals alone, but expectations and narratives can be powerful return drivers too. It's important to keep in mind that these narratives and expectations tend to shift over time.
From 1999 to 2009, China was entering international markets, commodity prices were booming, and emerging markets were growing at full speed. In this context, both emerging market stocks and international stocks in developed markets outperformed U.S. stocks by a wide margin. Emerging markets gained 188%, developed markets gained 12%, and U.S. stocks declined by 9%.
But in the past decade, there was a major reversal in performance. The U.S. economy performed relatively better, and many of the most successful tech stocks listed in the U.S. produced spectacular returns.
At the same time, Europe has been hurt by the debt crisis, Brexit, and all kinds of political upheaval, while emerging markets have been under pressure due to currency volatility, low commodity prices, and the trade war. This has allowed U.S. stocks to massively outperform international markets since 2010.
But this superior relative performance from U.S. stocks has produced a wide gap in valuations. The table below compares some key valuation metrics for the SPDR S&P 500 Trust ETF (SPY), the iShares MSCI EAFE ETF (EFA), and the iShares MSCI Emerging Markets ETF (EEM). International stocks are widely cheaper across the board.
|Dividend Yield %||1.99||3.5||3.6|
Data Source: Morningstar
In order to evaluate how relative valuation levels have evolved from a historical perspective, we can take a look at the Cyclically Adjusted Price-to-Earnings (CAPE) ratio over time. Based on this metric, the valuation gap is the widest it has been over the past 40 years.
Source: Mebane Faber
Valuation is just one of many return drivers for different markets. We also need to consider all kinds of variables related to earnings growth and institutional risk. However, the data shows that valuation can have a huge impact on both return and downside volatility.
The chart shows the relationship between CAPE ratios and subsequent returns for different markets over the long term. In long periods of time, the lower the CAPE ratio, the higher the returns that can be expected.
Source: Star Capital
Even more important, 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 for different markets will depend on a wide variety of factors, many of them unpredictable and even unknown. Nevertheless, the historical evidence is quite clear - the lower the valuation, the higher the potential returns and the lower the downside risk over long periods of time.
Momentum Is Favoring International Stocks
Valuation is a key driver of return and risk over the long term, but it's not a market-timing tool. If you want to identify the best entry times in different asset classes, price behavior is much more relevant.
The Asset Class Rotation Strategy is a quantitative system that rotates between 9 ETFs that represent some key asset classes.
- SPDR S&P 500 Trust ETF for big stocks in the U.S.
- iShares Russell 2000 ETF (IWM) for small U.S. stocks
- iShares MSCI EAFE ETF for international stocks in developed markets
- iShares MSCI Emerging Markets ETF for international stocks in emerging markets.
- Invesco DB Commodity Index Tracking ETF (DBC) for a basket of commodities
- SPDR Gold Trust ETF (GLD) for gold
- Vanguard Real Estate ETF (VNQ) for REITs
- iShares 20+ Year Treasury Bond ETF (TLT) for long-term treasury bonds
- iShares 1-3 Year Treasury Bond ETF (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 is allocated to short-term treasuries.
Among the ETFs that are in an uptrend, the system buys the top 3 with the highest risk-adjusted performance over the past 3 and 6 months. The portfolio is rebalanced monthly, and the benchmark is a globally diversified portfolio that is allocated 60% to stocks and 40% to fixed-income.
The charts below show the historical performance numbers for the Asset Class Rotation Strategy since January 2007. Both risk and reward have been quite solid over time.
Source: ETF Replay
Factors such as trend-following and relative strength produce attractive returns over long periods of time, but that doesn't mean that they will necessarily beat the benchmark in each and every year.
When different asset classes are going through major bull and bear markets, the strategy tends to do a great job at capturing those trends. The strategy had a big exposure to bonds in 2008 and to stocks in 2017. In those kinds of environments, a strategy such as this one generally performs very well.
On the other hand, in periods such as 2015, when trends are weak and different asset classes are moving mostly sideways, chances are that the strategy will deliver lots of false signals and, ultimately, mediocre returns. In simple terms, a strategy based on momentum works much better when momentum is strong across different asset classes.
Even for investors who don't invest in these kinds of strategies, they can provide valuable information to make decisions in the market. The strategy will be updated at the end of November, but it's worth noting that the system is currently recommending the iShares MSCI EAFE ETF, the iShares MSCI Emerging Markets ETF, and the Vanguard Real Estate ETF as the 3 funds in the portfolio.
A winning investment strategy doesn't need to be too complex or sophisticated. On the contrary, Leonardo da Vinci is credited for saying that simplicity is the ultimate sophistication.
Value and momentum are arguably the two most important return drivers to consider when investing. You want to buy cheap markets, and you also want to buy those cheap markets at the right time, meaning when they are starting to move in the right direction.
International stocks are much cheaper than U.S. stocks, and they are starting to outperform U.S. stocks lately. In plain English, both value and momentum are favoring international markets right now.
The ETF Rotation Strategy is updated monthly in The Data Driven Investor. A subscription to The Data Driven Investor provides you with solid strategies to analyze the market environment, control portfolio risk, and select the best stocks and ETFs based on quantitative factors. Our portfolios have outperformed the market by a considerable margin over time, and they are built on the basis of solid quantitative research and statistical evidence. Click here to get your free trial now, you have nothing to lose and a lot to win!
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Disclosure: I am/we are long BABA, MELI, BRF, KWEB, GVAL. 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.