Market observer Zach Karabell lays out the pros and cons of a sector that has disappointed in recent years.
FROM BARRON'S | FEBRUARY 27, 2015
Famed Nobel Laureate Robert Shiller made some waves recently when he suggested that he might sell his holdings of U.S. stocks and instead buy European equities. The reason? “Europe is so much cheaper.”
Well, it is a bit cheaper, with a forward earnings multiple just under 15, versus a forward multiple for the S&P 500 that is approaching 17. But European equities were also cheaper two years ago when many strategists and pundits were urging more investments in European stocks relative to U.S. equities. And that call at each point over the past few years has been, bluntly, wrong.
So is this the year that the call is finally right, or should we take some lesson from the past few years and conclude that as tempting as international equities might look, they will once again disappoint?
The case for emphasizing international equities over the United States has several angles. First is an argument based on valuation, which is what Shiller meant when he called European equities “cheap.” He could just as well have included other global markets. The MSCI EAFE index (which includes larger companies in developed markets such as Europe, Australasia, and the Far East) is lower than Europe’s alone, while emerging market stocks are barely trading at 10 times price-to-earnings (P/E).
These valuation gaps between the S&P 500 (which tends to be the proxy for U.S. equities) and the rest really started to open up in 2013; hence one reason for the multiyear tendency of market mavens and strategists to urge investors to overweight international stocks.
Valuation is sometimes treated as some scientific absolute: if stocks trade below their “historic” average, they tend to be viewed as inexpensive, and if they are above, then they are seen as costly. The same idea pertains to relative valuation.
The problem is that valuation doesn’t exist in some neat statistical vacuum. People buy and sell whatever they buy and sell based on a whole range of factors, both relative and absolute. Interest rates, housing prices, GDP growth, how a specific company is doing and is expected to do—all of these factors shape decisions, as they should. How stocks behave is less mechanistic than you would think given much of market analysis, and nowhere is that more evident than in valuation discussions.
Another argument that is put forth in favor of international equities is that the future growth prospects are favorable. It is true that the growth prospects of many national economies outside of the U.S. were quite favorable in the past few years, ranging from China to India to Brazil to multiple Asian, Latin American and a smattering of other countries such as Poland.
The argument is somewhat different heading into 2015: now, with growth poised to surpass 3%, the U.S. is looking rather strong compared to many parts of the world that are seeing slowing GDP growth. Some of that global slowing is a direct consequence of the changing nature of China’s economic growth, which has been an anchor of many emerging market economies that have either benefitted from its formerly insatiable appetite for raw materials or from its outward investment. Now, with China shifting more toward a domestic consumer-based economic system, raw materials around the world are in high supply and less demand, which has negatively impacted many countries. But those countries are also shifting to greater focus on the domestic consumer, especially in India, Mexico, Indonesia, and Brazil, which have more than 2 billion people amongst them.
The euro zone is still barely hovering above a recession, but the argument in favor of European stocks is that the cycle is heading towards a modest recovery, with evidence of the same “green shoots” that were prevalent in the U.S. in 2009-2010 as the worst of the financial crisis subsided. Given that equities tend to price in future growth early rather than later, the time to buy is before the cycle has fully turned. Hence why now would be the time to buy the euro zone.
Finally, there is the relative performance argument: since U.S. stocks have been so strong the past few years while international names have lagged, it is time for a rotation. Even with U.S. economic growth trending up, earnings growth for many public companies appears to be slowing down. Time, therefore, to shift away from American stocks and towards the rest of the world.
…and the cons
Many pros have made the pro argument. But there is also a contrary argument that even though U.S. stocks have had a great run, it isn’t time to emulate Shiller or the market mavens.
The first argument against can be reduced to one word: Greece. Three years after the last tremors of the Greek crisis and the waves of fear that Greece would depart the euro zone and lead to an unravelling of the unified currency, we are back to the “Grexit” issue again. Now, however, markets and mavens are treating the prospect of a Grexit with equanimity. That may be appropriate, given that the overall size of Greek debt is about $400 billion and much of that is not held on a bank balance sheet. But Greece was never about its absolute size; it was about its symbolic position as the first country to leave the Euro, which could then embolden disenchanted populaces in Spain and Italy to do the same. And no one would deny that a domino effect dissolving the euro zone or throwing it in to turmoil would have anything but substantially negative effects on equity markets.
It’s not that a Grexit is likely, or that its effects are known. It’s that a Grexit presents a risk so substantial that if the worst-case comes to pass, you would not want to be long European equities when it happens.
Another con (and we mean that only in the sense of a negative, not in the sense of a scam) is that the macroeconomic fundamentals are weakening in much of the world outside of the U.S. As mentioned above, some of that represents a positive transition to domestic demand, but the bear case is that the macroeconomic outlook is less rosy globally. While it is a mistake to perfectly equate macro trends and equity trends, the softening of economic growth around the world could present some challenges for global companies.
The final con is that in a global world of commerce and trade, the U.S. and its companies are the best proxies for what is happening internationally. To put it differently, if international opportunities seem better, then U.S. listed companies, especially the S&P 500, are the best way to access that theme. About half the earnings of the S&P 500 come from outside the U.S., and if you take out health care service companies and some consumer staples and utilities, that percentage goes up even more. Hence buying larger and mid-sized U.S. companies is the best way to invest internationally.
If you add in the degree to which the dollar remains the sole viable global currency, the perceived stability of U.S. financial markets, and the effects of a stronger dollar possibly making investments outside the U.S. less effective for dollar-denominated accounts, the case against emphasizing international markets looks stronger.
What to do
The wrongness of the overweight international call for the past years should give all of us pause. But it is also true that past performance is no guarantee of future returns, and that this may indeed be the year that the call is right. The first two months of 2015 have seen substantial outperformance of non-U.S. equities, which is either a proverbial head fake or evidence that the year of international equities is finally here. And if risks such as a Grexit do not unfold, then the turn in the macroeconomic cycle and the shift to domestic demand around the world could be very positive for companies that sell to those markets and for investors who focus on them.
Here as in many things, the best course is to avoid the extremes. If you are going to overweight international, overweight, but not to the extent of selling U.S. and going all in. Themes matter as well: energy names are likely to be pressured regardless of national domicile; retail companies that sell to an emerging middle class are likely to be in strong position, all things beings equal. Valuation arguments that dominate many investing discussions may matter less than fundamentals.
And finally, even with the massive hiccup of the financial crisis, many industries are primarily global and hence the international versus U.S. dichotomy makes little sense. That is certainly true for semiconductors and luxury goods and oil service companies.
The best approach, then, is to start with where one thinks the best opportunities exist. Relative valuations, macroeconomics, political risk—those should be considered, but can also lead one into cul-de-sac after cul-de-sac. What is being bought where, what markets are expanding, and which companies are thriving—those questions will never lead us astray.