Does it make sense to invest anywhere but in the U.S?
While the S&P 500 (.SPX) is within 1% of its all-time high, European markets are flat, Chinese stocks are in a deep slump and the Japanese market—after a huge recent run-up—has finally clawed its way back to where it was 27 years ago.
Through Aug. 31, the S&P 500 has outperformed international stocks, as measured by the MSCI World ex USA Index, over the past one, three, five, 10, 15, 20, 25, 30, 35, 40 and 45 years, according to AJO, an institutional investment manager in Philadelphia. Had you put $10,000 in each in 1973 and reinvested all your dividends, your U.S. holdings would be worth $1.06 million; your international stocks, $356,000.
All those numbers seem to indicate you’d be crazy to diversify internationally. But, in fact, all they signify is that numbers can play tricks on you. It still makes sense to add international stocks to a U.S. portfolio, probably more so than ever.
Looking back in time from today, U.S. stocks seem to have dominated over the long run only because they have done so extraordinarily well over the past few years.
Lofted by a strong currency and trillions of dollars of fiscal and monetary stimulus, U.S. stocks rose so swiftly out of the financial crisis that they left the rest of the world behind. That spectacular recovery has obscured the historical record.
The U.S. was among the worst-performing stock markets worldwide in the 1970s and the 2000s; it also earned lower returns than the average international market in the 1980s.
Over the 10 years ended in December 1986, international stocks outperformed the U.S. by an average of 6.2 percentage points annually; even over the decade through December 2007, U.S. stocks lagged the rest of the world by an annualized average of 3.1 percentage points.
No one can say when that might happen again. Chances are it will.
Markets tend to lose their dominance right around the time it seems most irresistible. The Japanese stock market rose 22-fold over the 20 years through the end of 1989, making it the world’s best major performer.
If you were Japanese, that pinnacle of local out-performance marked the perfect time to diversify outside the country. The Nikkei 225 index, which hit its all-time high of 38915.87 on the last trading day of 1989, remains below 24000 as of this week.
“There have been many historical examples of countries that have risen and then fallen, either their economies or their markets or both,” says Marlena Lee, co-head of research at Dimensional Fund Advisors of Austin, Tex., which manages approximately $528 billion.
That’s far from saying that the U.S. will become the next Japan. “There’s no reason to believe that might happen here,” says Ms. Lee, “but you don’t have to make that call.”
If U.S. growth merely slows relative to other economies, stock markets elsewhere in the world are likely to catch up to or surpass the S&P 500.
Stocks in the U.S. may be more vulnerable than usual to such a reversal, given how expensive they are. Compared with the rest of the world, U.S. stocks are at their highest valuations on record, according to Bank of America Merrill Lynch—trading for twice as much, as measured by price to net worth, as international shares.
The rest of the world’s markets are less dominated, on average, by technology stocks than the U.S. and more focused on cheaper industrial and financial stocks, says Toby Thompson, a multi-asset portfolio manager at T. Rowe Price Group Inc. in Baltimore, which runs $1.1 trillion. The prices of such stocks outside the U.S. are “a lot more compelling,” he says.
What about the common objection that you can globalize your portfolio simply by holding such multinational U.S. companies as Coca-Cola Co. (KO) or Intel Corp. (INTC)?
Because such firms tend to hedge their exposures to foreign currencies, “what the U.S. economy and stock market are doing tend to overwhelm whatever benefits the companies get from being global,” says Mr. Thompson. Although they are multinational businesses, they still behave like U.S. stocks.
The biggest surprise is that individual investors have not abandoned global diversification during this recent period of disappointment.
Over the past 10 years, even as U.S. stocks hugely outperformed, mutual-fund and exchange-traded-fund investors took $34 billion out of U.S. funds and added $1.02 trillion to international, according to Fran Kinniry, an investment strategist at Vanguard Group.
Historically, investors have chased good returns and run away from bad performance, so “these numbers are kind of crazy,” says Mr. Kinniry. “This is incredibly contrarian compared to what we have seen in the past.”
Individual investors and their financial advisers, say Mr. Kinniry and other fund executives, seem to be adding money to international stocks as a systematic way of taking some money off the table as U.S. shares keep rising.
Sooner or later, that’s likely to make the so-called dumb money look smart.
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