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%.1 Exhibit 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 is another 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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S&P 500® Index
The S&P 500® Index is a capitalization-weighted index of 500 stocks intended to be a representative sample of leading companies in leading industries within the U.S. economy the index includes reinvestment of dividends but does not include fees, expenses, or taxes.
MSCI USA Index
The MSCI USA Index is designed to measure the performance of the large- and mid-cap segments of the U.S. market. With 635 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the United States.
MSCI AC World Index
The MSCI AC World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets.
MSCI EAFE Index (Europe, Australasia, Far East)
The MSCI EAFE Index (Europe, Australasia, Far East) is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada.
MSCI Emerging Markets Index
The MSCI Emerging Markets Index is designed to measure equity market performance of emerging markets.
TOPIX (the Tokyo Stock Exchange Tokyo Price Index) is a free-float adjusted market capitalization-weighted index that is calculated based on all the domestic common stocks listed on the TSE First Section.
Mutual funds and exchange traded funds are subject to market risk and volatility. Shares may gain or lose value. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. The alternate weighting approach (i.e., using revenues as a weighting measure), while designed to enhance potential returns, may not produce the desired results.
These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.