Opinion: Is investing in foreign stocks a good idea?

How many years of underperformance do you have to endure before you have the right to quit international equities?

Many of you are wondering because, contrary to the endless recommendations of retirement financial planners to be internationally diversified, US stocks continue to outperform. This year, it’s not even close: the SPX of the S&P 500,
-2.27%
the year-to-date return is 26.3%, compared to only 11.0% for the MSCI Europe, Australasia and Far East index (as measured by the iShares MSCI EAFE ETF EFA,
-2.69%
).

This year, however, is no exception. Over the past decade, the S&P 500 has doubled the annualized return of the iShares MSCI EAFE ETF from 17.2% to 8.6%. And over the past 15 years, the annualized return of the S&P 500 is almost three times as high, from 10.5% to 3.7%.

For this column, I review, once again, the case for international diversification, seeking to see if anything has changed that would require changing traditional financial planning advice.

Diversification

One of the main reasons why international diversification is recommended is its ability to reduce portfolio volatility. As modern portfolio theory teaches us, since non-US stocks are not correlated with US stocks, a portfolio of stocks split between the two will be less volatile than a portfolio that invests only in US stocks. .

There is, however, an Achilles heel in this argument: US and international stocks are less correlated during bull markets, and they become highly correlated during bear markets and crashes. These characteristics significantly reduce the benefits of international diversification, as it would be better if the reverse were the case.

That’s because we don’t really want diversification when the US market is up. Rather, we need it when the US market is down, and yet that is precisely when the correlation between US and international stocks is highest.

This is illustrated in the accompanying chart, which plots the correlation of monthly returns over the last five years of the S&P 500 and the EAFE ETF. Note that correlations jump during bear markets.

As an example, consider the stock market waterfall in February and March of last year, when the COVID-19 pandemic brought global economies to a complete halt. For the month of February, the S&P 500 lost 8.1% while the EAFE index lost 8.2%. In March, both lost 12.4%. Thus, during these two months, international diversification produced no benefit.

Also note that the correlation between the two markets is much higher today than it was in the 1990s. This is relevant because the traditional arguments for international diversification are largely based on historical results. from a long time ago. If the correlations are consistently higher today than before, this is another reason why the traditional rationale should be discarded.

None of this is to say that there are still some volatility-reducing benefits of international diversification. After all, as you can see from the chart, the correlation between domestic and international stocks is not 100%. Nonetheless, it seems likely that these benefits are significantly lower than they were decades ago.

To the extent that your rationale for international diversification reduced volatility, you might want to reconsider.

Evaluation

The other major argument in favor of international equities is based on relative valuations. The US market will rarely be the cheapest, so regular rebalancing of its equity portfolio in global markets will automatically cause you to periodically sell high and buy low. It’s not a bad idea.

There really is such an opportunity today. Consider how the US stock market compares to other countries based on the cycle-adjusted price-to-earnings ratio (or CAPE), the valuation ratio made famous by Yale University finance professor Robert. Shiller. At the end of the third quarter of this year, the U.S. CAPE stood at 37.1, higher than all but one of the other developed-country markets, according to the Barclays indices. Europe’s CAPE is 23.6, UK’s is 17.3, Hong Kong’s is 18, and Australia’s is 23.4.

So consider what international diversification offers an investor who is worried about valuations. Since it focuses solely on the US market, this investor has little choice but to build up cash. If it diversifies internationally, however, it can maintain its expected equity exposure while also investing in stocks that are more undervalued.

The easiest way for most individual investors to invest in non-US stocks is to use an exchange traded fund compared to a broad index. Besides the iShares EAFE ETF, another often mentioned in newsletters that my company monitors is the Vanguard Total International Stock ETF VXUS,
-2.86%.

For a speculative bet on international stocks, you can consider investing in Turkish stocks. ETF TUR iShares Turkey,
-4.27%
is currently recommended by one of the top performing investing newsletters my company monitors, even though stocks across the country have had a really bad year. But, largely because of its poor performance, the country’s stocks are heavily undervalued, according to its CAPE ratio. In fact, among the 26 markets for which Barclays Indexes reports a CAPE, Turkey is the cheapest with a CAPE of 7.5, or one-fifth of the ratio of the United States.

However, don’t allocate more than a small percentage of your stock portfolio to Turkish stocks.

Mark Hulbert is a regular contributor to MarketWatch. Its Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. He can be contacted at [email protected].


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