It’s often said that investors are their own worst enemies. One reason this seems to be true is because they tend to have very short memories. It wasn’t all that long ago I was getting questioning calls from nervous investors asking why they had such a heavy allocation to U.S. stocks, typically about 60 percent.
When the financial crisis first hit the United States in 2008, Europe was perceived mostly as an innocent bystander to the financial carnage. As a result, it became seen as a likely safe haven.
Over the five years prior to the crisis, 2003 through 2007, the S&P 500 Index returned 12.8 percent per year while the MSCI EAFE Index returned 22.1 percent and the MSCI Emerging Markets Index returned 37.5 percent. In other words, the MSCI EAFE and Emerging Markets indices outperformed by 9.3 percentage points and 24.7 percentage points, respectively.
Looking at total returns presents an even more dramatic picture. Over this period, the S&P 500 returned 82.9 percent, the MSCI EAFE returned 171.2 percent and the MSCI Emerging Markets returned 390.8 percent.
Given the dramatic differences in returns, it was very difficult as an advisor to keep investors disciplined. My message was simply that these types of divergences in returns are to be expected, although they happen in unexpected ways, and we diversify across the globe because we don’t have clear crystal balls to tell us which countries will perform the best, and neither does anyone else.
I would explain that there would almost certainly be periods when U.S. stocks underperform, and just as certainly there will be periods when they outperform.
The Virtue Of Discipline
The key to being a successful investor isn’t about being able to forecast which markets do well when, despite what Wall Street and much of the financial media would like you to believe.
Instead, it’s about remaining disciplined and firmly adhering to your asset allocation plan. And that means having the courage to rebalance back to your target allocations, which can involve buying assets that have done poorly and selling assets that have done well.
Most investors are not able to do this on their own. In fact, the evidence clearly shows investors, as a whole, are performance chasers, selling what has done poorly (at relatively low prices) and buying what has done well (at relatively high prices). And that’s not exactly a prescription for investment success.
Compounding the problem caused by five years (2003-2007) of dramatic underperformance on the part of U.S. stocks were concerns raised by the financial media about the likelihood, if not certainty, that, as a result of the financial crisis, the U.S. dollar would lose its status as the world’s reserve currency. That only served to heighten concerns about the outlook for U.S. equities.
In case your memory is short (no one is talking any longer about the dollar losing its status, to be replaced by the euro or even the Chinese yuan), here are some examples of the headlines from just a few years ago:
- In June 2010, the United Nations released a report that called for abandoning the U.S. dollar as the main global reserve currency, arguing it had been unable to safeguard value. The report received support not only from Russia and China, but also from Nobel Prize-winning U.S. economist Joseph Stiglitz.
- In November 2010, China and Russia announced they would renounce the U.S. dollar and resort to using their own currencies for bilateral trade. In the same month, China announced plans to boost cross-border yuan-denominated trade with other countries to 20 percent of total trade, a tenfold increase, to reduce reliance on a few reserve currencies.
- In February 2011, the International Monetary Fund issued a report on a possible replacement for the dollar as the world's reserve currency, saying that special drawing rights could help stabilize the global financial system.
Currency: Not As Important As You’d Think
When the issue of the dollar losing its status as the world’s reserve currency arose, I went to my trusty videotape to demonstrate that, even if this should occur, it wasn’t necessarily a bad thing for U.S. stocks. I noted the British pound had been the world’s reserve currency before our dollar replaced it.
World War II had devastated the British economy, and the pound suffered as well. We have data on the FTSE All-Share Index going back to February 1955. At the time, the pound was worth $2.80.
Today, it’s worth about $1.51, a drop of about 46 percent. With a loss of that size in the value of its currency, you might think that U.K. stocks would have done poorly relative to U.S. stocks. You’d be dead wrong.
Over the 60 years from February 1955 through January 2015, the FTSE All-Shares Index returned 10.64 percent on an annualized basis, outperforming the S&P 500 Index, which returned 10.30 percent. While the British pound lost about 46 percent of its value, British stocks in pound terms rose more than sufficiently to offset that loss.
The Perils Of A Stronger Dollar
Here are some key points to help you remember why currency movements aren’t necessarily the dominant determinant for stock returns, or even really a major contributor to them. The most important item to recall is that if investors expect the U.S. dollar to rise, that expectation is already built into stock prices all around the globe.
It’s only the unexpected that determines the majority of the differences in returns. Thus, the risk is really in whether or not the dollar was to rise more than already expected.
Second, a rise in the value of the dollar has some negative consequences for U.S. companies. To start, overseas assets and earnings of U.S. multinationals are now worth less. Their profits are now lower, all else being equal. But all else isn’t equal.
Since the dollar’s current rise isn’t related to higher eurozone inflation, causing the euro to fall in value, U.S. exporters now must compete with cheaper locally produced goods. And U.S. domestic producers now must compete with cheaper imports, putting pressure on profit margins.
In each case, the reverse is true for foreign companies. A more expensive dollar gives them less competition in their local and U.S. markets, helping them with sales and profit margins.
We are already seeing the impact of the stronger dollar in somewhat-lower profit margins and lower earnings estimates from U.S. multinational companies. The reverse is true for companies in other developed nations that are benefiting from the same stronger dollar. Growth estimates for the GNP of other developed nations are experiencing some acceleration.
Here’s another interesting bit of information for investors who believe a rising dollar dooms foreign stocks: On Jan. 1, 2015, the euro stood at about $1.21. By March 10, it had dropped to about $1.05.
Yet, despite a decrease of 13 percent in such a short period, through March 10, Vanguard’s Vanguard Total Stock Market (VTI | A-100) had returned 1.2 percent and outperformed Vanguard’s 500 ETF (VOO | A-97), which posted a loss of 0.3 percent.
The Longer View
To be successful, investors must have a long-term perspective. To take the longer view, we’ll examine the returns for the last 15 calendar years (2000-2014). That includes the dramatic underperformance of U.S. stocks from 2003 through 2007 as well as their dramatic outperformance from 2008 through today.
Over this period, the S&P 500 Index returned 4.2 percent, the MSCI EAFE Index returned 3.0 percent and the MSCI Emerging Markets Index returned 7.4 percent. An annually rebalanced portfolio allocated 60 percent to the S&P 500, 30 percent to the MSCI EAFE and 10 percent to the MSCI Emerging Markets would have returned 4.4 percent.
Since no one knows whether the next few years will look more like 2003 through 2007 or more like 2008 through 2014, global diversification of economic and geopolitical risks is the prudent strategy.
Before closing, there’s one additional important point we need to cover. The underperformance of international stocks over the past seven years has led to valuations quite a bit lower than valuations of U.S. stocks.
Because valuations are the best predictor we possess for future returns, foreign stocks now have higher expected returns than U.S. stocks. Of course, those lower valuations likely reflect, at least in part, the risks of the dollar strengthening.
Current Valuations & Expected Returns
As of the end of 2014, the Shiller CAPE 10 ratio for the S&P 500, which uses the last 10 years of earnings (adjusted for inflation), produced an earnings yield (the inverse of the P/E ratio, or E/P) of 3.8 percent.
To adjust for the fact that real earnings grow over time—and we are analyzing earnings that are on average five years old—we need to multiply the earnings yield by 1.1, producing an earnings yield, and a forecast of expected real returns, of about 4.2 percent for the S&P 500.
Using the same process, we find the CAPE 10 ratio will produce a yield of 6.3 percent for the MSCI EAFE Index, and an expected real return for stocks in that index of 6.9 percent. Finally, the CAPE 10 ratio for the MSCI Emerging Markets Index produces an earnings yield of 7.0 percent, and an expected real return of 7.7 percent for stocks in that index.
Using this metric, we can see that U.S. stocks should be expected to underperform foreign developed-markets stocks by 2.7 percentage points and emerging market stocks by 3.5 percentage points.
We can also see evidence of the differences in valuations (and thus the expected returns) by looking at various value metrics for three of Vanguard’s ETFs in the table below.
|Fund||Price to Earnings Yield (%)||Earnings Yield (%)||Price to Book||Price to Sales||Price to Cash Flow|
|Vanguard Total Stock Market (VTI | A-100)||17.6||5.7||2.4||1.6||9.9|
|Vanguard Total International (VXUS | A-99)||14.9||6.7||1.5||1.0||5.3|
|Vanguard Emerging Markets (VWO | C-81)||12.9||7.8||1.5||1.2||4.1|
Data: Morningstar, as of Jan. 31, 2015
Higher Valuations Aren’t All Bad
As you can see, regardless of which value metric we examine, U.S. valuations are now much higher than international valuations, especially in the valuations for emerging markets.
Now, it’s important to understand that doesn’t make international investments a better choice. Their higher valuations reflect the fact that investors view the U.S. as a safer place to invest. And there is an inverse relationship between risk and expected return (at least there should be).
We live in a world where there are no clear crystal balls. Thus, the prudent strategy is to build a globally diversified portfolio. But that’s only the necessary condition for success. The second part, the sufficient condition, is to have the discipline to stay the course, ignoring all the clarion cries from those who think their own crystal balls are clear. As Warren Buffett explained, “The most important quality for an investor is temperament, not intellect.”
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.