It may be time for investors to increase their exposure to foreign stocks.
Thanks to years of underperformance relative to their U.S. brethren, foreign stocks are relatively cheap, some experts say. They point to the fact that while the S&P 500 index (.SPX) has risen an annualized 10.8% over the past 10 years, the MSCI EAFE Index (.EAFE), which measures developed countries outside the U.S. and Canada, has risen only 3.9%, and the MSCI Emerging Markets Index (.MXEF) 5.3%. The foreign increases are in dollar terms.
“Stocks are significantly cheaper in other parts of the world,” says Bill Stone, co-chief investment officer at wealth management firm Avalon Advisors in Houston.
As of Oct. 31, the forward-looking price-to-earnings ratio, based on earnings estimates for the 2018 calendar year, for the S&P 500 stock index was 16.43, compared with 13.39 for the MSCI Europe Index (.MSCIEU), 12.1 for the MSCI Japan Index and 10.87 for the MSCI Emerging Markets Index, according to Bloomberg.
Stagnant share prices abroad also have helped boost dividend yields. As of Oct. 31, MSCI Europe sported a yield of 3.98%, MSCI Japan stood at 2.45% and MSCI Emerging Markets at 3.21%, compared with 2.03% for the S&P 500.
“Based on current valuation levels, which help play a role in determining equity returns over the next several years, foreign markets appear more attractive than U.S. markets,” says Michael Sheldon, chief investment officer at RDM Financial Group-HighTower Advisors in Westport, Conn.
Not everyone is bullish about foreign stocks. Some advisers see political and economic troubles brewing, particularly in the European Union. Some analysts are concerned about instability for the EU and the euro, pointing to Italy as a potential trouble spot because of concerns about the new populist government there and its economic policies. Others worry about Britain’s planned exit from the EU, saying a hard exit would hurt the economies of the U.K. and continental Europe.
To be sure, concerns about Europe’s economic problems are pushing down the euro, which is good for European stocks, says, Karim Ahamed, an investment adviser for wealth management firm HPM Partners in Chicago. Euro weakness boosts European companies that sell overseas, making their products less expensive in foreign-currency terms and making their foreign revenue worth more in euro terms.
“That may be the silver lining in the cloud,” Mr. Ahamed says. The euro was at about $1.14 at the start of November, down from $1.25 on Feb. 1.
Mr. Ahamed also has concerns about Japan, where the stock market touched 27-year highs in September and the yen has become something of a safe-haven currency. A strong yen hurts Japan’s stocks, because many of its companies are dependent on exports.
Avalon’s Mr. Stone views the country more optimistically. “We are overweight Japan,” he says. “It has high-quality companies holding lots of cash, and corporate governance has improved.” While Japan’s economic growth is slow, export-focused Japanese companies can benefit from a stronger economic expansion elsewhere in the world, he says.
Emerging markets’ lure
Experts agree that the best long-term investment prospects lie in emerging markets, thanks to their strong economic growth. For the next 10 years, Ivan Hoffman, managing partner of Fi3 Financial Advisors in Indianapolis, and his colleagues forecast annualized stock-market returns of 8.9% for emerging markets, 6.9% for developed markets excluding the U.S., and 5.7% for the U.S.
Emerging markets, excluding their rally in 2017, have suffered in recent years amid weak commodity prices, slowing growth in China and tightening U.S. monetary policy. But the MSCI Emerging Markets Index’s 14% drop so far this year provides an “attractive entry point,” Mr. Hoffman says, despite persistent volatility.
Investing overseas entails currency risk. If foreign currencies fall, any holdings based in those currencies will be worth less in dollar terms. Some funds hedge against that exposure by using currency forward contracts. But given that currencies will fluctuate up and down over time, such contracts don’t have much of an impact on the funds’ long-term returns, says Dan Sotiroff, passive-strategies analyst at financial information firm Morningstar.
Specific overseas funds that Mr. Sotiroff recommends include Vanguard FTSE Developed Markets ETF (VEA) or its mutual-fund version Vanguard Developed Markets Index Admiral (VTMGX). “You’re getting access to broadly diversified developed-market exposure,” he says. And annual expenses are just 0.07% for both funds, putting them among cost leaders in the category.
The same factors—broad market exposure and low costs—lead him to favor iShares Core MSCI Emerging Markets ETF (IEMG) for emerging markets exposure and Vanguard Total International Stock ETF (VXUS) for total foreign-stock exposure.
Meanwhile, for a small slice of your foreign allocation, Mr. Ahamed recommends T. Rowe Price International Discovery Fund (PRIDX). It focuses on small-cap stocks, primarily in developed markets.
“Small-caps may be leaders in their local markets, but not globally, so they aren’t picked up by multinational fund managers,” he says.
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