Posted by on Nov 24, 2014 in Blog, Columns |

By Jason Zweig | 1:00 pm ET  Nov. 21, 2014
Image Credit: Christophe Vorlet

Foreign stocks are in the red this year, even after a rally on Friday, while U.S. indexes set record after record. Japan is in recession, Europe is stagnating and the dollar is booming.

 It’s understandable that U.S. investors in October pulled more than $2 billion out of international-stock mutual funds and exchange-traded funds, after adding an average of $16 billion a month in the previous year, according to Morningstar. That was the first monthly outflow in the past year, although preliminary data from research firms and EPFR Global show money flowing back in so far in November.

But it isn’t time to pull the plug on international diversification. “There’s definitely some performance-chasing going on, some currency-chasing going on,” says William Stromberg, head of equity at T. Rowe Price Associates in Baltimore. “Governments in Europe and Japan are determined to drive their currencies down against the dollar, and that scares a lot of people.”

The MSCI All-Country World Index, not counting the U.S., is down 4% so far this year in dollar terms, while the S&P 500 is up 13.1%, including dividends, through Thursday. That gap is nearly as wide in percentage terms over the five years through Oct. 31.

Still, there are plenty of reasons for U.S. investors to hold foreign stocks. The People’s Bank of China and European Central Bank President Mario Draghi both made potentially bullish moves this week for investors in those markets.

More broadly, foreign stocks can be an effective hedge against a rise in U.S. interest rates.

Keith Parker, a strategist at Barclays in New York, recently looked back at returns since 1954 and found that U.S. stocks tend to go nowhere for at least six months after the Federal Reserve raises interest rates. But international stocks historically have outperformed the U.S. market by almost four percentage points in the sixth months after U.S. rate hikes, Mr. Parker found, probably because higher interest rates make future U.S. earnings less valuable to investors in the present.

With the Fed widely expected to begin raising rates sometime in 2015, having some of your stock money overseas could help cushion the blow.

From now on, says Mr. Parker, “It’s going to be more difficult for the U.S. to outperform [other markets], given higher valuations and the Fed shifting course,” as well as greater potential for a longer run of economic recovery overseas.

After years of outperformance, U.S. stocks have become much more expensive than those in the rest of the world.

Joachim Klement, chief investment officer at Wellershoff & Partners, a Zurich-based financial research and consulting firm, periodically calculates the value of stock markets based on the long-term average of their price relative to their earnings, adjusted for inflation. That measure, often called the “cyclically adjusted price/earnings ratio,” or CAPE, was devised by Yale University economist Robert Shiller.

As of Oct. 31, according to Mr. Klement, the U.S. traded at 24.7 times earnings by the Shiller measure, making it the second-most highly valued stock market in the world, after only Denmark at 26.9. Japan is at 20.9 times earnings; the U.K., Italy, Brazil, Spain, Austria, Hungary, Russia and Greece are all trading at less than half the valuation level of the U.S.

The rest of the world has been so disappointing for so long that it might not take much to generate a jump in returns. “If you get one whiff of good economic news in Europe, earnings will go up and stock prices could surprise on the upside,” says Mr. Stromberg of T. Rowe Price, “because expectations are so low.”

None of this means you should plunge into international stocks to the same extreme degree so many investors were doing until recently. But with such a long Ice Age of underperformance by non-U.S. markets, relatively cheap valuations overseas and the likelihood of rising rates in the U.S., it makes more sense than ever to spread some of your bets around the world.

Consider an exchange-traded fund like Schwab International Equity, iShares Core MSCI Total International Stock or Vanguard Total International Stock, none of which charges more than 0.18% in annual expenses, or $18 on a $10,000 investment. Or you can opt for a low-cost mutual fund that also spreads its bets widely outside the U.S., such as Fidelity Diversified International, T. Rowe Price International Stock or Vanguard International Growth, all with annual expenses of 0.92% or less.

John C. Bogle, founder of the Vanguard Group, says he doesn’t own any international stocks or stock funds, since he argues that Americans should fund their future spending with assets denominated in dollars. U.S. investors who do want foreign exposure should limit it to “no more than 20%” of their stock portfolio, he says.

On the other hand, when foreign markets get so cheap that “nobody wants them,” says Mr. Bogle, “then maybe we should take them a little more seriously.”


Source: The Wall Street Journal