August 5, 2019
Written by Matthew White, CFA®, Investment Analyst
International stocks have been a real bummer for investors over the last decade. In fact, while the S&P 500 has delivered a 294% increase for the ten years ending 6/30/19, developed international stocks and emerging markets have only provided 95% and 76% returns respectively over the same time period. To be sure, nearly doubling your money is not the worst thing that can happen to a person. But when your neighbor has quadrupled his, it does make you feel like a bit of a loser. However, investors who hold international stocks should not give up on them now. We believe that the very forces that have kept them from running up like U.S. stocks could be the same reasons they might have more upside over the next decade.
Part of the reason why foreign stocks haven’t had the same return as U.S. stocks lately is the rising U.S. dollar. A rising dollar means a falling Euro, Yen, Peso, etc. The strong dollar has provided a big headwind and detracted from international returns because investors have to translate foreign returns into U.S. dollars. If you have investments denominated in a foreign currency that declines, you will see that show up as a loss in your brokerage account. The same holds for buying a U.S. mutual fund that holds international stocks and American depository receipts.
However, the effect of currency on international returns moves in both directions, and there are extended periods where global stocks outperform due to a falling U.S. dollar. In this chart, when the line is increasing, the rising U.S. dollar hurts international returns; when the line falls, it helps them. We’ve come out of a decade of a rising U.S. dollar, but there are many reasons why that could be reversing. Among them, the U.S. is not increasing interest rates at a faster pace than foreign central banks anymore. It’s a bit of a foxhole to get into, but rising rates tend to boost a currency. We see in the Federal Reserve today a reluctance to increase rates or even have the conversation about dropping them. This approach is a significant reversal from the trend that has driven up the dollar over the last several years and could lead to a boost to international stocks ahead.
Source: JPMorgan, FactSet
Another reason why foreign stocks can end up out-performing U.S. stocks in the years to come is they are much less expensive than U.S. stocks. We see that in the table below.
Source: JPMorgan, FactSet, MSCI, S&P. Data as of 6/30/19. P/E is the forward price/earnings ratio based on the most recent index price divided by consensus earnings estimates for the next twelve months. US stocks represented by the S&P 500. Foreign stocks represented by MSCI ACWI Ex-US. The dividend yield is forward-looking.
In the first column, we see the valuation levels based on price to earnings – that is, how much a stock costs per $1 of profits. When you buy stocks as an intelligent investor, you are buying profits. You can see that foreign stocks will give you a higher level of profit for your investment than U.S. stocks. We put this in relative terms in the bottom row where we show that foreign stocks are 20% less expensive to buy than U.S. stocks.
There is a caveat to this which is that, in general, foreign stocks historically have traded at a discount to U.S. stocks. We see that in the next column over; those international stocks are usually 11% cheaper. However, this would still imply, compared to history, that there is a 10% extra upside to foreign stocks relative to their U.S. peers. We’re not saying these stocks are bound to outperform U.S. stocks over the next year, but discounts in relative value do tend to play out as higher expected returns over the long run.
We use terms like stock valuations and discounts, but you can relate it to your own life. When you buy anything at a discount, you can buy more of it. Therefore, as an investor trying to gather as many assets as possible to meet your goals, we continue to believe that diversifying internationally and buying at a discount is a smart move.
 International developed stocks represented by MSCI EAFE NR USD. Emerging markets represented by MSCI EM NR US.