When Journey keyboardist Jonathan Cain was a struggling musician in Los Angeles, he’d call home in despair.
“Don’t stop believing or you’re done,” was his father’s advice.
The same could be said today to investors wanting to give up on international stocks. Through yesterday, foreign shares have underperformed large cap U.S. stocks by nearly 8% per year over the past decade.
But memory is fleeting, and it was not long ago the same investors were likely the very ones clamoring for international stocks.
Remember the “Lost Decade”? That was the stretch from 2000 through 2009 during which U.S. stocks actually lost money—a 10-year period over which $1 invested in the S&P 500 turned into 91 cents.
Today, the record is turned. Lagging international stocks are what’s giving investors reason to sing the blues.
But don’t stop believin’. Giving up now on international stocks could be a big mistake.
Risk and Return Are Linked
Let’s remember that times like this are part of investing. One asset class performs well for a period until a different part of the portfolio takes the lead. It goes on and on and on and on—that’s just part of the investment journey.
But in the long run, U.S. and international stocks should provide similar returns. After all, each exposes investors to the same fundamental risk—an ownership stake in publicly traded corporations.
Because risk and return are inherently linked, similarly sized companies in Denver and Denmark should offer investors similar return opportunities. There’s nothing about a border that destines a company in one country to underperform or outperform its foreign counterpart.
The Valuation Cycle
And don’t forget, the attractive returns we’ve enjoyed from U.S. stocks since the global financial crisis have pushed valuations (i.e., price-to-earnings ratios) higher. All else equal, this implies lower future returns.
Today, the CAPE ratio—a measure of how expensive the S&P 500 is relative to its own history—is nearly double its historical average. The last time large U.S. stocks traded at this level was in 2001.
How did U.S. stocks fare the last time they appeared this pricey? For the 10 years that followed, the S&P 500 delivered cash-like returns, while lower-priced international value, small cap, and emerging markets small cap stocks surged 180%, 230%, and 540%, respectively.
Why the large disparity in returns? Starting valuations.
Back in 2001, international and emerging market stocks traded at much lower valuations than did their U.S. stock counterparts. This paved the way for higher expected—and, in fact, realized—returns.
This isn’t too different from where we are today. Non-U.S. stocks are currently trading at a 25% discount to large cap U.S. stocks.
While this doesn’t guarantee future international stock returns will be better, it would seem to stack the odds in disciplined investors’ favor.
The Perils of Chasing Returns
By now, you’re likely thinking to yourself: I’ve heard this before.
And you’re right—we’ve sung the “patience and discipline” song many times. And each time, you’ve agreed to stick to the plan.
But patience may be wearing thin. Surely, 10 years is long enough to prove that U.S. stocks are just fundamentally better, right?
No. It is precisely at times like this that such thinking has gotten investors into past trouble.
Let’s consider what would happen if, instead of remaining disciplined, you owned what we call a “rearview portfolio.”
The rearview portfolio adjusts its allocation between U.S. and international stocks to favor only the previous period’s best performer.
For example, if you started with a 70/30 split between U.S. and international stocks—and 10 years later U.S. stocks had outperformed international stocks—you switched your allocation to 100% U.S. for the next decade.
After another 10 years, you switched again, loading up on the prior decade’s best performer.
Applying such a strategy to a starting $100,000 portfolio in 1970 would have resulted in a portfolio worth $4.1 million today.
That’s not bad—until you compare it to the performance of a rebalanced portfolio that maintained fidelity to the original mix of U.S. and international stocks. Today, that portfolio would be worth $10.7 million.
That’s the value of discipline.
History as Teacher
Nearly a half century of data tells us that giving up and switching between U.S. and international stocks every 10 years has been a mistake.
It is patience and discipline, not rolling the dice, that offer the best chance for long-term investment success.
So, don’t stop believin’. Hold on to those international stocks.
