Over the past five years, U.S. stocks have outperformed international developed market stocks by 6.84% and outperformed emerging markets by a massive 12.01%.1Exhibit 1. In response to events such as the sovereign debt crises, the Chinese currency devaluation, and prolonged economic growth challenges across the globe, investors may have rightfully favored U.S. stocks over their international peers.
Investors may have also been disappointed by the persistent lack of earnings growth coming out of non-U.S. regions. Since the global financial crisis of 2008-2009, earnings have held up better in the United States than they have in either international developed or emerging markets. Exhibit 1
Recent history aside, it’s still important to remember that the U.S. equity market represents only 53% of the world’s market capitalization, while U.S. investors have nearly 75% of their equity portfolios in U.S.-focused mutual funds and ETFs, evidence of a significant home country bias.2 In fact, that bias has grown over the recent past, rising from a low of 71% in September 2010. As the United States has outperformed, investors have not added to international equities in proportion to their relative returns.
In response to U.S. equities’ outperformance, valuations for the U.S. stock market have risen sharply. Since 2009, the average price-to-sales ratio of U.S. equities have been steadily rising above its historical average and well above that of international developed and emerging markets, which have not moved significantly above their historical averages. Exhibit 2
Additionally, sector biases may play a role as the United States has a significantly greater exposure to information technology, a high margin businesses that generates significant revenue for companies. As a result, IT stocks, in general, can have a higher price-to-sales ratio than the stocks in many other sectors do.
Even with the potential for these differences, Exhibit 3 paints an interesting picture. In this case, the MSCI EAFE Index and MSCI Emerging Markets Index data from Exhibit 2 are directly compared with the MSCI USA Index to see if valuations are stretched compared with their history, on a relative basis. From this perspective, one can see that both EAFE and EM, on a historical basis, are undervalued.
It is clear that the U.S. equity market is certainly not inexpensive. But valuation, both when it’s attractive and unattractive, is not a reason for buying or selling in and of itself. Investors need a catalyst. Currently, the catalyst for looking outside of the United States may be found in recent improvements in economic data. Manufacturing activity outside of the United States seems to have been steadily improving since the midpoint of last year. Exhibit 4
The improved economic growth backdrop has translated into higher estimated earnings-per-share growth outside of the United States. Exhibit 5. This trend isanother positive development that is making the case for looking at international developed and emerging markets again.
Looking ahead, investors may still be wary of opportunities in international developed and emerging markets, so they may want to look for an increased margin of safety by tilting toward companies with attractive fundamentals. A revenue-weighted strategy will more heavily weight companies with lower market capitalizations and will be more focused on companies with lower valuations than the overall benchmark index – a potential benefit given that value is one of the key factors that have historically been strong predictors of excess return.
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