March 29, 2021: International Stocks vs. US Stocks | Better Financial Future -- MyPlanIQ

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International Stocks vs. US Stocks

International stocks are still cheaper and they are doing better now. In this newsletter, we review their valuation and discuss their roles in our asset allocation portfolios.

Recent returns

We have long argued that one needs to diversify among international stocks (both foreign developed country stocks and emerging market stocks). However, for the past 11 years or so, US stocks have continued to defy many, outperforming foreign stocks by a large margin.

Let’s first take a look at the returns for the past 10 years:

Global stock index comparison (as of 3/26/2021):

Ticker/Portfolio Name	YTD Return**	1Yr AR	3Yr AR	5Yr AR	10Yr AR	15Yr AR
VTI (Vanguard Total Stock Market ETF)	6.4%	60.0%	16.9%	17.0%	13.9%	10.1%
VEA (Vanguard FTSE Developed Markets ETF)	5.4%	49.9%	7.2%	10.2%	6.2%
VGK (Vanguard FTSE Europe ETF)	5.5%	47.9%	6.4%	9.4%	5.8%	4.5%
VWO (Vanguard FTSE Emerging Markets ETF)	3.7%	52.4%	6.1%	11.9%	3.5%	5.7%
JPXN (JPXN)	4.1%	41.8%	7.3%	10.5%	6.9%	2.8%

**: NOT annualized YTD: Year To Date

The outperformance of US stocks over other international stocks is more than 2:1 in terms of annualized returns for the past 10 years. Among them, Emerging market stocks have lagged way behind (13.9% vs. 3.5% annualized return in the past 10 years).

Furthermore, even in the past one year since the low of the pandemic, only emerging market stock index (VWO) briefly surpassed US stocks (VTI) in Feb. 2021. The US is still leading the pack:

International stocks have much cheaper valuation

However, one can’t simply ignore an important fact: international stocks have much cheaper valuation. Shiller’s CAPE 10 (Cyclical Adjusted Price Earnings ratio) is defined as the the average price over earnings ratio in the last 10 trailing years. Though it’s still debatable on whether this is the best stock valuation metric, it’s no doubt to provide some good insightful information into expensiveness of stocks.

The following chart from Barclays compares the Shiller’s CAPE ratios of the US, Europe and Japan:

The US’s CAPE-10 ratio has been highest since 2000. European’s CAPE is now about the level in 2008 while Japan’s CAPE is also about the level in 2008-2009.

The next chart compares the US’s CAPE with a bunch of emerging market countries’:

One can see that the US’s CAPE is again the highest, compared with the other countries’.

Cheap valuation & global tactical stock asset rotation

Of course, an argument against using stock valuation as the sole factor to guide investing is that cheap valuation doesn’t equal to better returns. Actually, it’s very simple and intuitive to understand this as a stock (or a stock index that one can view as the stock for a conglomerate, see October 12, 2020: Stock Indexes As Businesses) that has higher price earnings (PE) ratio but also has much higher future earnings growth should be valued higher than a stock with low PE ratio but grows earnings much more slowly. At the end of the day, it’s how much earnings/profit a company or a collection of companies make matters. Higher or lower PEs are just some first level metrics. On the hand, if both company grows earnings at a similar pace, the cheaper one should certainly be valued higher.

So simply relying on cheaper valuation such as CAPE is not reliable. It can give investors some sense but that’s about it.

Unfortunately, it’s very hard to accurately predict future economic growth, let alone earnings growth. However, we can at least do some rough examination.

We can compare the US with Europe and the emerging market countries separately.

In terms of the US vs. Europe, based on OECD, it’s expected to grow at 3.5% and 3.25% respectively in 2021 and 2022. The US GDP, on the other hand, is expected to grow at 6.5% and 4% respectively for 2021 and 2022. Structurally, one can see that the US, as a more monolithic country, will grow better in a longer term. So it does somewhat justify the US’s higher valuation. Note here, we use GDP growth as the proxy of the earnings growth. This by itself is a very rough approximation.

On the other hand, emerging market economic growth is expected to be much higher. For example, based on OECD, growth in 2020-24 in Emerging Asia was expected at 5.7% on average.

The other factor that can affect stock prices is the so called risk premium that can be understood as the extra return investors demand because of higher uncertainty in terms of future growth estimation. In this sense, emerging market economies are highly volatile and more uncertain, compared with the US and other developed countries, thus, it would demand lower valuation for emerging market stocks.

Finally, there is another implementation factor that investor should consider: the currency impact. Many index funds are US dollar denominated (at least for the US based investors). These include the ETFs listed above, for example. As the US has poured huge stimulus money to counter the pandemic recession (the most recent one being $1.9 trillion), it’s very likely eventually the US dollar will be valued lower, compared with other currencies. That would itself lift up the relative prices of foreign stocks.

All in all, the above discussions are pointing to a mixed picture on foreign stocks. Our sense is that developed country stocks are somewhat comparable to the US stocks, after many years’ depressed returns. On the other hand, emerging market stocks, with their lower valuation and higher growth prospective, are likely to return better in the future. But such prediction can be unreliable, especially for some short periods like the next 5 years or even 10 years.

In our opinion, the best approach here is to diversify among these stock assets. For a Strategic Asset Allocation (SAA) portfolio, different weights should be assigned to these assets. For a Tactical Asset Allocation(TAA) portfolio, however, using these asset classes’ price momentum as a guide to select top performing assets for intermediate term investing can hopefully capture returns of rising assets. This is evident in the following comparison:

The two portfolios are listed on Advanced Strategies page.

Market Overview

Last week, a mini market disruption on Friday cost some banks (Credit Suisse and Nomura) significant earnings. A hedge fund (Archegos) was forced to liquidate its highly leveraged positions, causing stock prices of ViaComCBS and Discovery, plus a few Chinese stocks to plummet (see CNBC report). In the current highly overvalued and overextended markets, we are seeing more and more such mini disruptions recently (remember the Gamestop stock fiasco in February?). Though these events haven’t caused much damage to broad market indexes, it’s not an encouraging sign to see more and more such small events are occurring in a heated market.

We reiterate 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 now reached another high. 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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