January 16, 2023: International Stocks In Asset Allocation

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Regular AAC (Asset Allocation Composite), SAA and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Wednesday February 1, 2023.

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

International Stocks In Asset Allocation

After more than a decade of lack luster returns, international and emerging market stocks have started to outperform their US counterparts. In this newsletter, we will review past performance and current valuation. We then proceed to discuss our asset allocation strategies in the coming years.

Returns of international stocks are catching up

Since the great financial crisis in 2008, international and emerging market stocks had been in a dog house for so long. However, in last year, they started to outperform US stocks.

The following table and chart show their relative returns, compared with US stocks:

International stocks vs. US stocks (as of 1/13/2023):

Ticker/Portfolio Name	YTD Return**	2022	3Yr AR	5Yr AR	10Yr AR	15Yr AR
VEA (Vanguard FTSE Developed Markets ETF)	7.3%	-12.8%	5.1%	3.2%	5.9%	3.2%
VWO (Vanguard FTSE Emerging Markets ETF)	8.1%	-16.6%	0.1%	0.2%	2.2%	1.4%
VTI (Vanguard Total Stock Market ETF)	4.6%	-18.4%	8.4%	9.1%	12.4%	9.5%

1 year chart

Since 2008 chart

We can see that the underperformance began in 2011 when US stocks (VTI (Vanguard Total Stock Market ETF)) started to outperform international and emerging market stocks (VEA (Vanguard FTSE Developed Markets ETF and VWO (Vanguard FTSE Emerging Markets ETF).

From the above data, one can see that these two assets (represented by VEA and VWO) had been relatively flat in the last decade. This had contributed to the underperformance of most global asset allocation portfolios that have substantial allocation to them. In fact, the standard 60% US stock and 40% US bonds allocation index fund VBINX (Vanguard Balanced Index Fund) had handily beaten almost all of those that have allocation to these other assets.

However, the tide started to turn in 2022 as we can see from the table above. Year to date, they also outperformed the US so far.

Attractive valuation

Even with last year’s outperformance, international and emerging market stocks still have much lower valuation than that of the US stocks. The following charts compare the CAPEs (Cyclically Adjusted Price Earnings, defined as the ratio of price over trailing 10 year average earnings) among the regions and countries (The following data are all from Barclays)

The first to notice is that Europe’s CAPE in aggregate is still much lower than the US’s. Notice that historically, the US have commanded a slightly higher CAPE. But even after taking this into account, Europe’s CAPE at 19.2 is still way cheaper than the US 27.5.

After much up and down in the last 20 years (or 40 years since 1980s), Japan’s CAPE has been flat (and much lower than the US) for the past 10 years. Now it is about the same as Europe’s:

Moving to emerging markets, with Russia mostly out of picture, we look at those of China, India, Brazil and South Africa:

Granted, investors still have hefty concern on whether China is investable. But its valuation is (understandably) very cheap. It’s a bit concern that India’s valuation is now more expensive than the US high. Others like Brazil, South Africa and Mexico still have quite a bit discount.

Tailwind for international stocks

Aside from the cheap valuation, the following factors can be tailwind to international stocks:

Inflation in Europe has stabilized as Europe has made good progress to wean off its energy reliance on Russia. Not only some countries have started to resurrect their abandoned nuclear power plants, they also have lessened or slowed down aggressive efforts to phase out fossil oil and gas in order to make more smooth transition to green energy. All of these actions are net positive to lower energy cost.
The strength of US dollar is fading. This will be another positive contribution to the US dollar denominated international stock prices.

The European Union is taking a more balanced act between the friction of the two largest economies: the US and China. It will benefit from both sides’ desire to court its support and will actually have more bargaining power in return.
Euro zone’s economy surprisingly showed its resilience in the recent inflation episode. It’s now more and more likely that they can avoid a recession this year.
Finally, the war between Ukraine and Russia is drawing closer to the end with Russia pretty much giving up its intention to occupy the large part of Ukraine. If the war ends, the rebuild of Ukraine will be a boost to many European (and US too) economy.
China is reopening up and it’s expected to further strengthen global supply chains and consumption, assuming no geo and local political upheavals.
Brazil is emerging out of its slump while India has been growing faster than other countries.

What to do

In the coming months, we will start to change allocation to international stocks in both our tactical strategies (AAC and TAA) as well as our strategic asset allocation SAA. We believe that international stocks deserve higher allocation in one’s overall investments, given the secular trend change under way.

We caution that there have been several false starts for international stocks for the past decade as they were much cheaper than the US. However, the positive factors outlined above will have major impact in the years to come.

Market overview

Investors started to chase risk asset prices higher after a more positive CPI report. Recent market actions (stocks up, bonds up) are mostly from investors’ belief that global economy (mainly the US and the Europe) will narrowly avoid a recession this year, a so called ‘soft landing’ situation. At this moment, the main uncertain factor is that the labor market is still too hot that might still put more pressure on wages. If the wage pressure continues, the Federal Reserve will be forced to continue to hike interest rates (although at a slower pace and smaller scale). This again might tip the economy back to its weak trend.

We are also entering the earnings report period. At the moment, it’s expected that corporate earnings will be affected by rising interest rates. If the earnings indeed surprise on the downside, stocks will be again pressured. Subjectively we believe it’s too early to tell whether we are out of the woods.

As always, we advocate a risk managed approach and let prevailing market conditions and actions guide us further. We call for staying the course:

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 preferably much longer given the current high valuation. 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 and preferably many more 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 has dropped and now valuation is becoming less hostile. However, it is still not cheap by historical standard. For the moment, we believe it’s prudent to be extra cautious. 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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