During the last 10 years, international markets have disappointed, producing returns that are not quite half those of U.S. markets.1 Over the past five years, the S&P 500 is up 10.78 percent2 while the MSCI EAFE Index is up 4.81 percent.3 The last decade has seen the largest 10-year outperformance by the U.S. (nearly eight percent annually)3 since records became available in 1970. As such, there are a couple things we should keep in mind moving forward.
First, assets don’t indefinitely outperform or underperform. Returns historically have a way of reverting back to their means. As seen in the chart below4, the U.S. has outperformed about half of the time, and international outperforms the other half. Further, the underperformer in the prior decade becomes the outperformer in the following decade over 80 percent of the time. The larger the underperformance in the prior decade, the larger the outperformance tends to be in the next.
Second, there are several factors contributing to the U.S.’s recent outperformance, but a major reason has been the strength of the U.S. dollar.5 Two to three percent of the previous decade’s outperformance can be attributed to the appreciation of the U.S. dollar.6 The dollar has appreciated by about 20 percent over the last five years.7 However, the dollar too has tended to revert back to its mean. Over the last 50 years, the dollar has declined on average against a basket of foreign currencies8, and we expect the dollar will likely continue to follow this longer-term trend.
Third, despite the recent underperformance of international assets, it’s important to remember why we hold them in our portfolios. These assets tend to behave differently than U.S. assets, which offers diversification. International assets hedge against dollar decline, one of the primary risks to U.S. consumers and our wealth’s purchasing power.
Finally, investors have paid up for U.S. assets. Investors are willing to pay a premium for companies domiciled in the U.S. for their more stable earnings and higher growth. The need for economic reform in many developed countries, as well as political risks in emerging ones, has caused investors to worry about growth in those countries. We would expect these perceptions to continue.
However, these perceptions have created an opportunity in international assets. These assets generally have lower price-to-earnings ratios, lower price-to-book ratios and lower price-to-dividends. As seen in the chart below9, the U.S. is above its long-term average valuation mark, while developed and emerging economies are trading below average valuations.
This means that much of the fears over these markets is already priced into international assets. Historically, investors find lower-priced assets have higher expected returns. Conversely, much good news is priced into U.S. markets, which will likely put more pressure on those investments if earnings don’t keep pace.
We believe U.S. market exposure should remain the core holding in most investors’ portfolios. We believed this a decade ago when U.S. investments were underperforming during the height of the mortgage crisis10 and emerging markets were the darling of investors. Ten years later, the U.S. markets have been the best performer and now have become the most expensive equity assets. Holding on to non-U.S. assets should provide us with diversification from whatever might cause the U.S. or the dollar to go through a decade of underperformance, as it has done in the past.
1. DFA Returns 2.0
2. Yahoo! Finance – S&P 500
3. MSCI.com – MSCI EAFE Index
4. Exencial study based on DFA Returns 2.0, S&P 500 TR and MSCI EAFE ex Japan GTR in USD
5. CNBC.com – The US dollar just hit a two-year high and is threatening to make another major milestone
6. MarketWatch – U.S. Dollar Index (DXY)
7. DFA Returns 2.0, MSCI.com
9. J.P. Morgan Guide to the Markets, 9/30/2019
10. Investopedia – Subprime meltdown
PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE RETURNS. Information and opinions provided herein reflect the views of the author as of the publication date of this article. Such views and opinions are subject to change at any point and without notice. Some of the information provided herein was obtained from third-party sources believed to be reliable but such information is not guaranteed to be accurate. In addition, the links provided within are for convenience only and the provision of the links does not imply any sponsorship, endorsement, or approval of any of the content. We do not guarantee the content or its accuracy and completeness. The content is being provided for informational purposes only, and nothing within is, or is intended to constitute, investment, tax, or legal advice or a recommendation to buy or sell any types of securities or investments. The author has not taken into account the investment objectives, financial situation, or particular needs of any individual investor. Any forward-looking statements or forecasts are based on assumptions only, and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. Any assumptions and projections displayed are estimates, hypothetical in nature, and meant to serve solely as a guideline. No investment decision should be made based solely on any information provided herein and the author is not responsible for the consequences of any decisions or actions taken as a result of information provided in this book. There is a risk of loss from an investment in securities, including the risk of total loss of principal, which an investor will need to be prepared to bear. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. Exencial Wealth Advisors, LLC (“EWA”) is an investment adviser registered with the Securities & Exchange Commission (SEC). However, such registration does not imply a certain level of skill or training and no inference to the contrary should be made. EWA may only transact business in those states in which it is registered, notice filed, or qualifies for an exemption or exclusion from registration or notice filing requirements. Complete information about our services and fees is contained in our Form ADV Part 2A (Disclosure Brochure), a copy of which can be obtained at www.adviserinfo.sec.gov or by calling us at 888-478-1971.