Long-Term International Expectations

There’s a scene in the 1986 movie “Crocodile Dundee” where the tough Australian namesake character and his date are mugged by a young man with a small pocket knife. Dundee’s date is frightened and says to do what the mugger demands, because he has a knife. “That’s not a knife,” says Dundee, reaching into his shirt, “this is a knife”. He pulls out a comically huge bowie knife, causing the mugger to run for his life, clearly outmatched.

When people refer to value stocks in the United States, that scene comes to mind these days. “That’s not value. This is value,” I think to myself, pointing at international stocks. Nobody wants them, there’s a lot of bad news there, and they’re cheap. Many quality companies around the world are inexpensive compared to their U.S. counterparts, even when normalized for growth and sector.

Decades of evidence show that cheaper markets tend to outperform expensive markets over the long-term. It’s a hard thing to do in practice, and feels painful during some years, but allocating capital to regions around the world that are cheap and out of favor historically works very well.

This article (no paywall), for example, compiles several decades of evidence showing that, over the long run, overweighting cheaper markets tends to outperform the S&P 500 over time.

I personally like to dig deeper than just valuation to look at debt, growth rates, currency fundamentals, and political stability, to get a more holistic idea of how attractively-valued a given market is and minimize exposure to value traps. For example, in my global opportunities report from earlier this year, Argentina earned the lowest score out of 30 countries analyzed due to its currency issues, and that situation has unraveled so far this year. 

At the current time, even when discounting for some global issues, many international equity regions are a bargain relative to U.S. equities.

The U.S. Premium: Big and Likely Temporary

The United States is currently home to less than 5% of the world’s population, about 15% of the world’s PPP GDP, about 24% of the world’s nominal GDP, and about 56% of the world’s stock market capitalization.

However, this wasn’t always the case. For example, in the 1980’s, the United States market was very cheap relative to the rest of the world, and Japan’s overvalued total stock market capitalization briefly surpassed that of the United States despite having a significantly lower GDP.

Each decade or business cycle tends to overvalue a given region, and for just the past few years, this has become the United States. In the late 1980’s, Japan reached extremely high valuations and went on to underperform the rest of the world for the next decade. In 2000, the United States had extremely high valuations, and went on to underperform the rest of the world for the next decade. In 2007, emerging markets had extremely high valuations, and went on to underperform the rest of the world for the next decade. In 2019, the United States has among the highest valuations globally. Time will tell how this plays out this time around.

Over the past business cycle, since the previous cycle top twelve years ago in 2007, the U.S. stock market has absolutely crushed foreign developed markets (EFA) and emerging markets (EEM). It’s not even close:

 While there have been multiple factors involved, including demographics for Japan and Europe, expanded valuations have been the biggest component. Aggressive fiscal policy by the United States has been another major component as well.

For example, from 2007 to 2019, the revenue per share of the S&P 500 grew by 32% while S&P price per share increased by over 100%.

Back in 2007, the U.S. market was cheaper than most other places based on the cyclically-adjusted price-to-earnings (CAPE) ratio. Now it’s higher than most other places:  

Deflating valuations have significantly hurt foreign stock performance, and that’s a phenomenon to be cautious of going forward for the United States.

In addition, the trade-weighted dollar index appreciated by over 10% during that time, which is another layer of returns that helped boost U.S. stock performance in USD terms.

Over the past five years, emerging markets have had 12.1% earnings growth, the U.S. has had 10.7% earnings growth, and foreign developed markets have had 8.6% earnings growth, according to Vanguard’s data:

Chart Source: Vanguard

Based on price-to-earnings ratios, the S&P 500 is at least 25% more expensive than foreign counterparts. Based on price-to-book ratios, it’s over 100% more expensive. When normalized for sector differences, this valuation divide only shrinks mildly.

State Street estimates that the S&P 500 will have 11.78% annualized earnings growth over the next 3-5 years, foreign developed markets will have 8.24% earnings growth, and emerging market will have 11.47% earnings growth. This data is averaged from FactSet, Reuters, I/B/E/S, and First Call. This growth rate difference shrinks when dividend yields are added in, because emerging markets currently yield higher than U.S. stocks, and foreign developed markets yield higher than both, due to valuation differences.

Forward growth is of course uncertain, but we have a situation where overall past and forward growth rates vary mildly between major regions, but valuation levels differ significantly. The PEG ratios of foreign equities are, as a whole, more attractive than the U.S. broad PEG ratio. In addition, a variety of factors including a dollar liquidity shortage are propping up the strength of the dollar, further boosting U.S. market capitalization compared to the rest of the world in USD terms.  

If this reverses at some point, the U.S. market could be a significant laggard over the next decade. Valuations can’t tell us almost anything about short-term or even intermediate-term forward performance, but they historically tell us quite a bit about long-term forward performance.

Age and Bonds

As one final note, the U.S. median age is 38, in Europe it’s 43, and in Japan it’s 47. The older demographics and slower population growth are significant factors that cause those regions to have slower GDP and earnings growth than the United States. In several emerging markets (not all), there is the opposite effect, with younger populations that are growing more quickly.

This recent chart from J.P. Morgan shows the bond weight of pension funds and insurance companies in Japan and the Euro Area compared to the United States, and the difference is striking:

Those regions have significantly higher bond weighting than in the U.S. Unsurprisingly, we see that their bond prices are much higher (with unprecedented negative nominal yields) compared to current U.S. bond valuations (which are high but not to the same degree), as their appears to be insatiable demand for bonds at any level in those regions.