Underwater Overseas

Underwater Overseas

Jonathan Clements
Director of Financial

It all seems so obvious.

The U.S. economy remains robust, with unemployment at a nine-year low and real GDP growing at an annualized 3.5% in the latest quarter. Meanwhile, overseas markets are confronting the double whammy of political upheaval and economic malaise.

So why own foreign stocks?

Before we hit the sell button, maybe we should take a moment to play market strategist. The game is simple enough. All you have to do is figure out three numbers: the current dividend yield, how fast corporate earnings will grow, and what valuation investors will put on those earnings.

To make it even easier, we already know the first number. U.S. stocks—as measured by the S&P 500—currently yield some 2%. To forecast the market’s return over the years ahead, we just need to estimate how fast corporate profits will expand, and predict whether investors will grow more or less optimistic, as reflected in the market’s price-earnings multiple. Let’s say U.S. earnings per share climb 5% a year. If the market’s P/E ratio stays the same, share prices would also climb 5%. Add the 2% dividend yield and—bingo!—we have a 7% total return.

Easy, right? To be sure, predicting what will happen to P/E ratios is a little tricky. But we can be fairly confident the U.S. economy will grow a whole lot faster than Europe and Japan. Emerging markets should grow faster still, but all that could change if we get a global trade war.

This sort of analysis would strike most folks as entirely reasonable, and it makes sense at a gut level. We instinctively assume that today’s most successful economies and markets will keep on shining, and that the laggards will continue to struggle. Yet there’s a good chance the above analysis will prove dead wrong.

Why? When playing market strategist, it’s crucial to keep three key notions in mind. First, markets are fairly efficient, meaning they should be priced to deliver returns that reflect the risk involved. If U.S. and U.K. large-cap stocks are of roughly equal risk—which seems like a pretty solid assumption—we should expect similar long-run returns from both markets. If U.S. small-company stocks and emerging markets are somewhat riskier, we should expect higher returns. If that wasn’t the case, why would anybody take the added risk involved?

Second, past performance is a rotten guide to the future. We regularly publish a periodic table showing the variation in performance of different asset classes from one year to the next. You can create a similar table for decade-long returns—and what you find is that all parts of the global market have had periods of strong performance, but those are often followed by stretches of weaker results.

Consider three slices of the global stock market: U.S. large-company, U.S. small-company, and developed foreign markets. Among those three sectors, the top performers were U.S. small-cap stocks in the 1970s, foreign stocks in the 1980s, U.S. large-cap stocks in the 1990s and U.S. small-cap stocks in the 2000s.

After their chart-topping performance in the 1970s, small stocks fell to third place in the 1980s. That pattern—where one decade’s winner became the next decade’s laggard—has persisted in each decade since. Admittedly, small stocks, which were star performers during 2000-09, are on track to repeat that strong performance in the current decade, but we still have three years to go.

Third, and perhaps most surprising, strong economic growth is a terrible predictor of investment returns. Instead, a much better predictor is low valuations. In other words, if you had to choose between investing in an economy with high growth and investing in a market with modest valuations, you would want to go for the latter.

For proof, consider a study by academics Elroy Dimson, Paul Marsh and Mike Staunton. They looked at how you would have fared if you had invested each year in the national stock markets with the best and worst economic growth over the prior five years. During the 105 years studied, buying the fastest-growing 20% of countries would have delivered 5% a year, while investing in the slowest-growing countries delivered 8%.

One possible explanation: Investors get too excited by rapid growth and overpay for the stocks involved. Even if growth remains strong, the stocks often perform poorly, as valuations drift lower. Meanwhile, the slow-growth countries are more likely to deliver pleasant surprises—and investors enjoy not just better-than-expected earnings growth, but also rising stock valuations.

Today, foreign markets offer weak economic growth, but modest valuations. Will overseas stocks shine in the decade ahead? I’m not willing to wager my entire portfolio on that possibility. But I also wouldn’t want to bet against a rebound in foreign markets—which is why I’m happy to keep a healthy portion of my portfolio invested abroad.