Publications

- November 1, 2018: Vol. 5, Number 10

Should they stay or should they go? This is not the time for investors to start shedding international stocks from their portfolios

by Gregg Fisher

A change in market climate in 2018 has weighed on foreign stocks. The escalating trade war between the United States and China, the world’s two largest economies, has created uncertainty. The U.S. dollar, after weakening throughout 2017 and into January of this year, has surged nearly 8 percent in value (as measured by the Dollar Index Spot) since Feb. 1, 2018, perhaps due to rising U.S. interest rates and stronger economic growth. Currencies of developing countries with large quantities of U.S. dollar-denominated debt (including Turkey, Argentina and Indonesia) have suffered sharp declines in value.

Result: Year-to-date through Sept. 30, while U.S. stocks (S&P 500 Index) gained 10.6 percent, the MSCI EAFE Index of foreign-developed countries fell 1.4 percent and emerging markets (MSCI EM Index) slumped 7.7 percent. Since many investors are questioning their portfolios’ foreign-stock exposure, now is the opportune time to conduct a bit of research into the merits of maintaining a global (instead of U.S.-centric) equity portfolio.

PAST AND FUTURE

An investor who flits from foreign to U.S. stocks now due to the recent performance gap is acting on what is called recency bias in behavioral finance, or a tendency to make decisions by looking through the rear-view mirror. The U.S. market certainly looks strong now, but extrapolating past events and patterns into the future is always a risky game. For one thing, equity valuations in the United States are quite high both on a relative (e.g., the S&P 500 Index’s price-to-book ratio of 3.5 is more than double that of foreign markets) and on a U.S.-historic basis, which implies lower returns moving forward. Besides, it’s a big world out there: The United States accounts for one-half of the world’s stock market capitalization, but less than one-quarter of global GDP, about 10 percent of globally listed securities, and less than 5 percent of the world’s population.

The economy and corporate earnings appear robust in the United States right now, but domestic equities may have already discounted this current strength. I make no predictions, but I do note that the U.S. environment is not without risks for the market. For instance, interest rates are rising and the yield curve has dramatically flattened, which is often a precursor to slower economic growth. This year’s boost to earnings and economic expansion from the sharp tax cuts will likely start to fade in 2019; the federal budget deficit has ballooned this year, despite strong economic expansion, and is projected by the Congressional Budget Office to reach $1 trillion in 2019. When it comes to tariffs and protectionism, I doubt any economist has a crystal ball for determining the exact implications of rising trade tensions for U.S. growth, employment or earnings.

Apart from the current issues of valuations and risks in the United States, I think it makes eminent sense to maintain a healthy weighting in foreign stocks (for instance, a 30 percent to 35 percent allocation) in a globally diversified equity strategy. As with currency movements and growth vs. value and small vs. large caps in stocks, U.S. and foreign equities tend to move in somewhat different cycles. Since we discourage attempts at market timing and cannot predict when a cycle will begin or end, long-term investors are wise to hedge bets by adhering to a globally diversified portfolio.

THE GLOBAL PORTFOLIO

The accompanying bar chart compares the performance of U.S., international and global portfolios from 1970 to this year. Interestingly, even though U.S. stocks outperformed foreign ones in terms of both return and volatility, the global portfolio still achieved the highest return with the lowest volatility (i.e., the highest Sharpe ratio). This 2+2>4 result speaks to the benefits of combining asset classes with less-than-perfect correlations in a diversified portfolio.

Of course, few of us are able to invest over a 49-year timeframe. Therefore, we also compared performance using 10-year rolling returns, a statistically robust method that moves 10-year periods forward a month at a time across the entire 1970 to 2018 time horizon. We found that the same global portfolio, as defined in the exhibit above, outperformed the U.S.-only one in 61 percent of 10-year time periods, while the U.S. portfolio held the upper hand in 39 percent of cases.

In sum, I would advise against jettisoning foreign stocks simply because they have recently trailed U.S. securities’ performance. Overseas exposure is an important component of portfolio risk management and, as our study shows, tends to reward long-term investors.

 

Gregg Fisher is the founder, head of research and portfolio strategy at Gerstein Fisher, and portfolio manager for Gerstein Fisher Funds. This article was originally published on the Gerstein Fisher website and can be accessed at this link: https://bit.ly/2PnjzRi

 

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