With the U.S. stock market at relatively high levels, now may be a good time to look abroad for equity exposure. There are a few factors that make foreign markets attractive at this time.
The U.S. market has vastly outperformed other developed country stock markets over the last ten years. Through the market collapse in 2008-2009 and the recovery since then, investors in the S&P 500 would be up by over 50% over the last ten years whereas most broad international indices are still showing a loss over that time period. This difference in performance has resulted in a substantial valuation gap: the Shiller CAPE for the U.S. stock market is well above its long-term average (and currently hovers around 28), whereas valuations for foreign markets are in the range of 15-18 times normalized earnings.
While the valuation argument above is not new - it could have been used to justify a preference for international equity exposure at any time over the past few years - the renewal of earnings growth in foreign markets is a fresh consideration. This earnings growth has not yet translated into substantial stock gains (in large part due to the overhang from geo-political events), but on a technical basis international markets are exhibiting a positive trend and stronger momentum. Although there can be no guarantees regarding the outcome of elections in Europe or discord in Syria, the fact that earnings are recovering provides a potentially important catalyst for further gains.
Perhaps the most important reason to consider international equity exposure is the most fundamental: the potential benefits of diversification. Investors seeking diversification could be excused for being less than impressed with foreign equities over the last few years. During the last ten years, the correlation between the S&P 500 and broad international indices has averaged around .90, indicating that the two moved up or down in unison as a result of concerted central bank actions and the prevalence of 'risk on / risk off' sentiments. At present however, the 60-day rolling correlation between the S&P 500 and developed market indices is below .70, and the correlation between the S&P 500 and emerging market indices is around .50. So, unlike the past few years, there are currently meaningful diversification benefits to be gained from international equity exposure.
Interestingly, the diversification is even greater when considered relative to domestic 'Trump trade' stocks. This is borne out by correlation data, but also by economic logic. For instance, U.S. small caps will likely thrive in a protectionist, strong dollar environment - which partially explains their initial rise following the U.S. election; conversely, large international companies will get a short-term boost when the dollar weakens. The divergence between the two groups was on display over the last month as the Russell 2000 was down over 1.50%, but both developed and emerging market indices rose. This suggests that investors may be able to decrease their overall portfolio risk by including both small cap and international equity exposures.
International equities are an important asset category for many portfolios. Investors that have been ignoring the group may want to give it another look....
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