Foreign Stocks And Global Asset Allocation
In this newsletter, we revisit and review foreign stocks (international developed and emerging market). Our goal is to again see whether these asset classes warrant more allocation weights, in light of their recent relatively low valuation and other conditions.
But first, let’s look at current market conditions as they have probably been in most people’s mind these days.
US stocks corrected violently
It turns out that this year’s January was the worst month for US stocks since the pandemic low in March 2020. Though the correction is not limited to US stocks, they did get hit hardest:
It’s interesting to see that VWO (Vanguard Emerging Market Stocks) almost recovered its loss while foreign developed market stocks VEA has also dropped much less than both US stocks (VTI) and US REITs (VNQ).
Of course, all of these are because foreign stocks had underperformed so much before this year:
|1Yr AR||3Yr AR||5Yr AR||10Yr AR||15Yr AR|
|VTI (Vanguard Total Stock Market ETF)||-6.7%||17.2%||20.1%||16.2%||15.0%||10.1%|
|VNQ (Vanguard REIT ETF)||-7.7%||27.6%||13.3%||9.4%||9.8%||6.1%|
|VEA (Vanguard FTSE Developed Markets ETF)||-4.4%||6.1%||11.0%||8.5%||7.4%|
|VWO (Vanguard FTSE Emerging Markets ETF)||-0.28%||-4.6%||9.5%||8.1%||4.2%||4.5%|
AR: Annualized Return. YTD is not annualized.
The above comparison has been all too familiar to investors, especially US based investors. US stocks have been a consistent winner since 2009.
We also take a note that US REITs (VNQ) has also corrected more in January. It’s also noteworthy that REITs have done way much worse for the past 10 and 15 years than US stocks in general (such as VTI or S&P 500 SPY). We attribute this to the strength of growth stocks in an US stock index. Like other financial stocks, REITs have been considered to be ‘value’ or slow growth stocks and they are usually lagging behind in a growth driven market.
The above numbers are only for broad base indices. ARKK (Ark Innovation ETF), a growth stock representative, has lost over -22% for the month and its value has been cut by more than half since its peak in last February. Many high flying stocks have lost even more.
We’ll get back to current market condition later in this article. For now, let’s take a look at foreign stocks.
Cheap foreign stocks
The first thing to know about foreign stocks is that they are relatively much cheaper than the US stocks. The following chart compares Shiller CAPE (Cyclically Adjusted Price Earnings ratio) of US stocks, European stocks, Japan stocks and a few other emerging market stocks. CAPE is the ratio of price over last 10 trailing years’ average earnings. It smooths out a particular year’s earnings gyration.
The following CAPE charts are from Barclays.
Since 2009, Europe’s CAPE has not even risen above its high in 2007. Japan’s CAPE trended down big time in the 2008 weak period. It then has been flat since. Relatively, it’s lower than the US, similar to Europe’s. The international developed market stocks mostly consist of European and Japanese stocks. At the moment, these stocks are about 40% cheaper than the US.
The following chart further compares US CAPE with the CAPEs of a few countries in the MSCI emerging market stock index.
Other than India, all other emerging market countries’ CAPEs are only about 40% or less of the US CAPE. So the discount is even bigger.
In addition to their cheapness, another argument to support emerging market stocks is that after the world exits the current pandemic, emerging market economies will recover faster than the US and thus their stock prices will recover more too.
However, it should be noted that emerging markets are much riskier and thus investors would certainly demand a bigger discount. Furthermore, in the event of the next bear market, emerging market stocks will usually suffer from bigger loss. We don’t see that this will be an exception going forward.
Currency effect on foreign stocks
Another important factor to look at foreign stocks is the currency effect. Note that the foreign stock ETFs we use in the above (as well as in our portfolios) such as VEA and VWO are US dollar-denominated. What that means is that a fund like VEA (Vanguard FTSE developed market stock ETF) takes investors’ US dollars and then convert them to a local currencies like Euro and then use the local currencies to buy local stocks. The daily value of this ETF is to take its local holdings’ local currency value (such as Euro in this example) and then convert it back to US dollar. So when an investor sells the ETF in open markets, she/he gets back US dollars (for US based investors).
From the above description, one can see that VEA and VWO are subject to the fluctuation US dollar exchange value to other local currencies. Some so called ‘currency hedged’ ETFs try to mitigate the effect by using currency derivatives (such as US dollar to Euro futures) to make sure the conversion is maintained at a constant level. Of course, as nothing is free, these hedged ETFs need to pay some cost for purchasing these futures. Furthermore, one can see that as ETFs like VWO need to invest in many countries so it can be only a rough measure to accurately hedge against each country’s currency.
In the following, we compare hedged vs. unhedged ETFs for both international and emerging market ETFs. To make comparison more accurate, we use EFA and EEM for developed market stock ETFs (in place of VEA) and emerging market stocks ETFs (in place of VWO) respectively.
|1Yr AR||3Yr AR||5Yr AR||10Yr AR||AUM ($B)|
|HEFA (iShares Currency Hedged MSCI EAFE ETF)||-2.6%||16.6%||12.4%||9.7%||$3.3|
|EFA (iShares MSCI EAFE)||-5.0%||4.7%||9.8%||7.6%||6.8%||$55|
|HEEM (iShares Currency Hedged MSCI Emerging Markets ETF)||-3.0%||-9.6%||8.2%||7.8%||$0.19|
|EEM (iShares MSCI Emerging Markets)||-0.0%||-9.0%||6.5%||7.8%||3.6%||$29|
|UUP (PowerShares DB US Dollar Bullish ETF)||0.9%||5.4%||1.3%||0.7%||2.0%|
AUM: Asset Under Management (in billion)
In the table, we also include UUP (PowerShares DB US Dollar Bullish ETF) that tracks US dollar value against a basket of other currencies. We can see that for the past 10 years, US dollar value has risen 2% against other currencies annually. For the past 3 years, it has risen 1.3% annually.
The hedged ETFs have outperformed unhedged ETFs by 2%-3% annually. This is certainly very meaningful. On the other hand, both hedged ETFs have much lower AUM (Asset Under Management) and thus less liquid. In fact, this has been one of our major concerns that make us hesitate to employ these ETFs.
Foreign stock exposure
From the above, we can see that foreign stocks (both developed and emerging markets) have been affected by their lower valuation as well as currency weakness against US dollar.
Regarding whether we should increase foreign stock exposure in our standard Asset Allocation Composite (AAC) based portfolios, we make the following observations:
- The relative lower valuations (thus cheaper) of foreign stocks are partially justified as in comparison, US is still a large, single uniform economic entity that boasts of more economic stability and free market (thus more shareholder friendly). Enterprises can leverage this uniform large market to scale and grow their products and services rapidly. This means it’s reasonable for investors to demand higher risk premium for stocks in other smaller and more fragmented markets. We believe that the foreign stock discounts are not as deep as what CAPE numbers in the above suggest. However, they are still cheaper even after taking the risk premium into account.
- US dollar strength has played a big role in making unhedged foreign stocks cheaper. It’s likely we might see a dollar weakness in the future that will reverse this secular trend.
- Our take is that tactically, before the next global bear market, unhedged foreign stocks might benefit from lower valuation and lower foreign currency prices. This would make them more attractive than US stocks after US stocks recover from their current correction lows (assuming the correction doesn’t develop into a full blown bear market). However, when the next bear market hits, we believe foreign stocks might suffer from as big or bigger loss than US stocks. In a word, it’s possible to be tactically allocate more to foreign stocks after the current correction runs its course.
- Regarding currency hedged foreign ETFs, we believe it’s still better off to leave these to more expert investors. We will revisit this in the future.
For expert subscribers, portfolios like P Composite Momentum Scoring Global Risk Assets on Advanced Strategies page already have a balanced allocation to foreign stocks when they have highest momentum scores. They will be able to take advantage of the strength of foreign stocks when their time comes.
Based on FactSet, one third of S&P 500 companies had reported their Q4 earnings last week and so far, the blended earnings (actual and expected) have constantly exceeded previous week’s number. As of last Friday, the blended earnings growth was 24.3%, better than 21.8% on 1/13/2021 that’s better than 21.4% expected on December 31, 2021.
Markets are now recouping loss fast. Currently, the Federal Reserve’s indication of interest rate hikes are countered by the possible economic slowdown that have been warned by several economists (including Goldman Sachs and Morgan Stanley). The Atlanta Fed’s GDPNow gauge is even forecasting a first-quarter GDP gain of just 0.1%. In essence, it’s not all clear that inflation will persist and/or economies can continue their recent strength. One might frame this period as interesting. In reality, however, it’s likely for this period to turn out to be a precursor to a big correction or to a big inflation dominated investment theme that’s been long forgotten for several decades.
In light of the current volatile markets, we call for caution and advocate the following practice:
- For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as what we have emphasized numerous times, when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years or longer. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
- For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially in a time like this. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This has been shown to be true time and time again.
Stock valuation is still extremely high by historical standard. For the moment, we believe it’s prudent to be cautious while riding on market uptrend. However how serious a correction might be, we have confidence in the US economy in the long term and thus in the stocks in aggregate. We just need to manage through interim losses carefully.
We again would like to emphasize that for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.
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–Thanks to those who have already contributed — we appreciate it.
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- January 26, 2015: Composite Portfolios Review
- January 19, 2015: Fixed Income Investing Review
- January 12, 2015: How Does Trend Following Tactical Asset Allocation Strategy Deliver Returns
- January 5, 2015: When Forecast Fails
- December 22, 2014: Long Term Asset Returns: How Long Is Long?
- December 15, 2014: Beaten Down Assets
- December 8, 2014: Implementing Core Asset Portfolios In a Brokerage
- December 1, 2014: Two Key Issues of Investment Strategies
- November 24, 2014: Holiday Readings
- November 17, 2014: Retirement Spending Portfolios Update
- November 10, 2014: Fixed Income Or Cash
- November 3, 2014: Asset Trend Review
- October 27, 2014: Investment Loss, Mistakes And Market Cycles
- October 20, 2014: Strategic Portfolios With Managed Volatility
- October 13, 2014: Embrace Volatility
- October 6, 2014: Tips For 401k Open Enrollment
- September 29, 2014: What Can We Learn From Bill Gross’ Departure From PIMCO?
- September 22, 2014: Why Total Return Bond Funds?
- September 15, 2014: Equity And Total Return Bond Fund Composite Portfolios
- September 8, 2014: Momentum Based Portfolios Review
- September 1, 2014: Risk & Diversification: Mint.com Interview
- August 25, 2014: Remember Risk
- August 18, 2014: Consistency, The Most Important Edge In Investing: Tactical Case
- August 11, 2014: What To Do In Overvalued Stock Markets
- August 4, 2014: Is This The Peak Or Correction?
- July 28, 2014: Stock Musings
- July 21, 2014: Permanent Portfolios & Four Pillar Foundation Based Framework
- July 14, 2014: Composite Portfolios Review
- July 7, 2014: Portfolio Behavior During Market Corrections
- June 30, 2014: Half Year Brokerage ETF and Mutual Fund Portfolios Review
- June 23, 2014: Newsletter Collection Update
- June 16, 2014: There Are Always Lottery Winners
- June 9, 2014: The Arithmetic of Investment Mistakes
- June 2, 2014: Tips On Portfolio Rebalance
- May 26, 2014: In Praise Of Low Cost Core Asset Class Based Portfolios
- May 19, 2014: Consistency, The Most Important Edge In Investing: Strategic Case
- May 12, 2014: How To Handle An Elevated Overvalued Market
- May 5, 2014: Asset Allocation Funds Review
- April 28, 2014: Now The Economy Backs To The ‘Old Normal’, Should Our Investments Too?
- April 21, 2014: Total Return Bond Investing In The Current Market Environment