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"Questioning the Merits of International Diversification" - Monthly Market Update - November 2016

| November 14, 2016
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Market Commentary, Investing, Stocks, Bonds, Financial Planning, Wealth Management

Market Performance Overview

 

 

Recently, we’ve received a few questions from clients questioning the merits of international diversification. It’s easy to understand why investors are inclined to doubt the benefits of international diversification considering the seemingly steady stream of negative headlines coming from overseas (e.g., Greek debt crisis, slowing economic growth in China, Brexit, etc.) and the extended run of poor performance of international stocks compared to U.S. stocks. Specifically, over the last ten years, as of October 31, 2016, foreign stocks from developed markets returned 1.2% per year and emerging market stocks returned 3.5% per year, as measured by the MSCI EAFE Index and MSCI Emerging Markets Index, respectively. Meanwhile, U.S. stocks, as measured by the S&P 500 Index, returned 6.7% per year.

In this month’s commentary, we’ll provide additional context around the recent underperformance of international stocks as well as briefly review the case for international diversification which we remain steadfastly committed to.

Let’s begin by taking a look at the longer-term track record of U.S., foreign developed and foreign emerging market stocks. The chart below displays annualized five-year performance of the U.S. stocks (represented by the Fama/French Total US Market Index), foreign developed market stocks (Fama/French International Index) and foreign emerging market stocks (Fama/French Emerging Markets Index) using monthly data beginning in January 1989.

 

A few key elements stand out on this chart:

  1. All three markets tended to move generally in the same direction either up or down reflecting the overall positive correlation among stock markets around the globe.
  2. The three markets didn’t move in perfect unison as the magnitude of five-year annualized returns differed—quite significantly—at any given point in time across the three markets.
  3. Market leadership changed periodically as no market was consistently either the top nor the bottom performer.

Points #2 and #3 above are central to the case for global diversification as a powerful risk management tool. Holding a globally diversified portfolio takes some of the guesswork of investing by positioning the investor to capture the market’s returns wherever they occur. And, because U.S. and international markets don’t move in perfect unison with one another, a globally diversified portfolio has the potential to realize a smoother overall return experience than a portfolio solely focused on U.S. markets. The recent relative underperformance of international stocks doesn’t in any way undermine the case for the risk mitigating benefits of diversification. In fact, the recent underperformance reminds us of what we once heard from an astute market observer “the problem with diversification is that it works—something is always underperforming.”

Turing our attention back to the longer-term performance of U.S. and international stocks, we think it’s helpful to look at the performance data displayed above in a slightly different way. In the chart below, rather than looking at the five-year annualized performance of each market individually as we did in the chart above, we instead plot the annualized five-year performance of both foreign market indexes relative to the performance of the U.S. market (i.e., we subtract the performance of the U.S. market from each of the other two indexes and then plot the results). Periods where the data points are plotted above the X-axis on the chart represent times where the international market indexes outperformed U.S. stocks over the preceding five-years, while periods when lines are below the X-axis represents times when international stocks underperformed their U.S. counterparts.

 

What immediately stands out on this chart is:

  1. The stark difference between the current state of trailing performance relative to where it was prior to the onset of the financial crisis in late 2007.
  2. The cyclical nature of the historical performance record as foreign markets have experienced extended periods of both outperformance and underperformance relative to the U.S. market.

As noted, the period since the beginning of 2008 has been disappointing for stock investors who’ve extended their allocations beyond U.S. boarders. During the eight-year period from the beginning of 2008 through the end of 2015, the Fama/French Total US Market Index returned 6.7% per year, while the Fama/French International Index returned 0.4% per year and the Fama/French Emerging Markets Index lost 1.6% per year.

In contrast, during the seven-year stretch from the beginning of 2001 through the end of 2007, foreign stocks handily outpaced U.S. stocks as the Fama/French International Index returns 9.5% per year and the Fama/French Emerging Markets Index returned a remarkable 25.8% per year, while the Fama/French Total US Market Index returned just 4.2% per year. Scantly anyone was questioning the merits of global diversification back then!

As we’ve seen, the experience of global investing over the last nearly three decades is a prime exhibit in the study of the cyclicality of investment returns. Experience and evidence such as this have taught us that just as trees don’t growth to the sky, no cycle or trend can go on forever. 

One potential explanation for this can be found in understanding the role that valuations play in influencing investment returns. Research has demonstrated that valuations are among the most effective predictors of future returns on stocks, as low initial valuations have historically been associated with high future returns and vice versa.[1] As it relates to cycles, it’s easy to picture how strong performance in any asset or asset class has the potential to lead to high valuations—and ultimately lower future returns. Similarly, poor performance has the potential to lead to low valuations—and subsequently higher future returns. The recent strong performance of U.S. stocks and poor relative performance of foreign stocks has led to the current situation where foreign stocks trade at attractive valuations compared to U.S. stocks on a variety of measures, thus potentially setting the stage for strong future relative performance, as the table below demonstrates.

 

We believe it’s essential, however, to recognize our limitations in predicting the future and to approach forecasting with a large dose of humility. Critically, we need to acknowledge: 

  1. The predictive ability of valuations has only been meaningful over intermediate (e.g., 5-10 years) horizons. As such, we don’t think anyone is able to reliably predict the specific timing of when international stocks may begin to outperform.
  2. Valuations have only explained approximately 40% of the variation in returns meaning that the majority of the historical variation in long-term returns is unexplained. As such, while this historical evidence suggests that it’s likely that foreign stocks will outperform over the next 5-10 years, it’s not absolutely certain that they will.

Ultimately, we remain steadfastly committed to a strategy of global diversification to ensure that our client’s portfolios are well positioned to capture the market’s returns wherever they occur. Further, so long as U.S. and foreign markets don’t move in perfect unison with one another, the case for diversification as a risk management tool remains robust. The underperformance of foreign stocks over the last eight years has not caused us to waver in our commitment to international diversification and, if anything, has led us to be even more optimistic about the future prospects for foreign stocks given their currently attractive valuations.

As always, please give us a call or send us an email with any questions you have of if you’d like to talk about your investments.

Kathmere Capital Management Investment Department

 

IMPORTANT DISCLOSURES

Past performance is no guarantee of future results.

The economic forecasts set forth in the presentation may not develop as predicted.

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment.

Stock investing involves risk including loss of principal.

The S&P 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.

The MSCI EAFE Index is a capitalization-weighted index of foreign developed market stocks.

The MSCI Emerging Market Index is a capitalization-weighted index of foreign emerging market stocks.

The Fama/French Total US Market Index is a capitalization-weighted index of all US operating companies trading on the NYSE, AMEX, or Nasdaq NMS.

The Fama/French International Index is a capitalization-weighted index of foreign developed market stocks.

The Fama/French Emerging Markets Index is a capitalization-weighted index of foreign emerging market stocks.

Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal and potential illiquidity of the investment in a falling market.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification and asset allocation do not protect against market risk.

Investing in foreign and emerging markets securities involves special additional risks. These risks include, but are not limited to, currency risk, political risk, and risk associated with varying accounting standards. Investing in emerging markets may accentuate these risks.

Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Private Advisor Group, a Registered Investment Advisor. Private Advisor Group and Kathmere Capital Management are separate entities from LPL Financial.

[1] See: Forecasting Stock Returns: What Signals Matter, and What do They Say Now?, Vanguard Research, Davis et al., October 2012.

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