Another article on international investing? Doesn’t the U.S. market always outperform? Aren’t there lots of problems overseas? Why do we need to deal with those issues?
All good questions. The short answers are: yes, we are writing another article on the benefits of international investing. No, the U.S. market doesn’t always outperform foreign markets. Yes,
there are lots of problems overseas. As for why we should deal with those issues, read on.
First, to set the record straight, while the U.S. market has outperformed international markets in six of the last seven years, relative performance between U.S. and international equities tends to be cyclical. Take a look at the chart below.
It shows that there are multi?year periods when the U.S. wins and multi?year periods when international wins. Are we about to embark on a period of international outperformance? We don’t know for sure, but the potential exists for international to start outperforming because of the wide valuation difference that has resulted from recent underperformance and the cyclicality of returns.
There is an old adage: price is what you pay, value is what you get. At this point in the cycle, we believe investors are paying less and getting more in the international equity markets than in the U.S. equity market. What is the basis for that belief? Take a look at this next chart from JP Morgan.
The graph on the left shows profits in four markets indexed to their levels in 2009. Notice that in the U.S., profits have about doubled from the Great Recession and Global Financial Crisis, and in fact have gone on to new highs versus their prior peak. Also, note that developed international profits, Europe in particular, have made little recovery over the same time period. Finally, emerging markets (EM) are about halfway between the U.S. and Europe after a quick recovery and reversal. It is likely that the International markets have a longer way to go in terms of earnings growth than the U.S.
The graph on the right shows valuations, with the purple bar marking the 25?year average. The U.S. price/earnings multiples are higher than their historical mean, while developed international price/earnings multiples are closer to their long?term mean, and emerging markets are below the long?term mean.
We would argue that in the U.S. equity market, investors are paying a premium multiple on profits that are likely closer to a cyclical peak. In the international markets, investors are paying an average multiple on profits that have a higher likelihood of experiencing further gains. As a result, we believe that investors are paying less and receiving more in the international equity market than in the U.S. equity market at this point.
International investing provides investors benefits of diversification. Some academics have likened diversification to the only “free lunch” available in finance. What are those benefits? Without getting too much into statistics and math, it comes down to correlations between asset classes. In short, international equities may zig while U.S. equities zag. Because of that, adding international equities to a portfolio is likely to reduce the risk (as measured by volatility) of the portfolio and may even increase the return in the long run. Reduced risk and/or increased returns are the benefits of diversification.
Now that we have (hopefully) convinced you that international exposure in a portfolio is a good thing to have, we don’t want to go overboard. Being U.S. based investors, we have a natural “home country” bias. That means that when we add international equity exposure to portfolios, we will still be mostly invested in U.S. equities. In addition, none of the conclusions above are written in stone, the financial markets are too uncertain for that. We do believe, however, that there is a strong case building for international exposure in a diversified portfolio at this point.
As always, we thank you for your support and encourage you to reach out to us with any questions you have.
Michael Santelli, CFA, is Director, Chief Portfolio Strategist, Portfolio Manager at Ancora Advisors LLC a SEC Registered Investment Advisor.
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