US stocks have outperformed international stocks for the better part of the last 10 years. During that time, US firms, generally, have grown faster and been more profitable than international firms. The US has less regulation and a better business environment than most international markets. Many US firms are global market leaders and just seem more innovative than international firms.
All the above statements are true. Yet it still makes great sense to have a significant allocation to international stocks. Here’s why:
The differences between US and international markets are already priced into those markets.
In an efficient market, stock prices are driven by future expected earnings. There is no reason (all other things being equal) that an investor would pay more for a dollar of future earnings from a US firm than for a dollar of future earnings from an international firm. Money is money.
For example, let’s say I believe the US market will generate $10 of future earnings and international markets will generate only $5 of future earnings. Then it shouldn’t matter to me if I pay $100 for a share of the US market or $50 for a share of the international markets. Either way I am paying exactly the same thing for a dollar of future earnings.
So, even if US firms operate in a more favorable business environment, grow faster, generate more earnings, and are generally more innovative than international firms you shouldn’t dump your international stocks. You should just pay less for them.
This is true, all other things being equal. But all other things are never equal. There are differences between US and international markets relating to taxes, currencies, regulations, political stability, and a host of other risks and issues.
These differences are also priced into the markets.
If “Mr. Market” has considered all the relevant factors, weighed them correctly, and there are no changes or surprises, then it should not matter if you own US or international stocks. All the differences between US and international markets should be reflected in their relative prices.
And that is exactly what happens. As of October 31, 2023, the average price/earnings ratio (P/E) of the stocks in the S&P US Total Market Index, which broadly tracks the US stock market, was 19.6. The average P/E of the stocks in the MSCI ACWI ex USA Index, which broadly tracks the international stock markets, was 12.6.
That means, in effect, that investors were willing to pay over 55% more to own a share of the US market than to own a share of the international markets. Mr. Market is performing as you would expect in a world where US markets are viewed more favorably, for the reasons enumerated above, than international markets.
So, even in a world where nothing changes, it makes sense to allocate a portion of your portfolio to both US and international markets. US and international markets do not rise and fall in perfect sync, so there is still a diversification benefit that comes with owning both. And owning international stocks expands the universe of market-leading brands available, which can decrease portfolio risk.
But the factors that go into Mr. Market’s calculations are highly dynamic. They can change rapidly and dramatically. Global economies compete for advantage. World events alter the fortunes of nations. There are winners and losers. The world is in a constant state of flux.
The way Mr. Market values assets changes too. Sometimes stock markets are “cheap,” and it costs less to buy a dollar of earnings. Sometimes markets are “expensive,” and it costs more. The relative valuation of US and international markets also changes over time, so the size of the gap between what investors will pay for US and international stocks varies. Changes in the factors considered by Mr. Market and changes in the way those factors are weighed and valued drive the relative valuation and performance.
For example, assume that both US and international economies are successful in improving their respective earnings environments. But assume that international firms improve their earnings growth rates more than US firms. If that happens, international firm share prices will be adjusted upwards at a higher rate resulting in higher performance relative to US firms.
In this scenario, international firms do not need to earn more than US firms on an absolute basis to outperform them. They simply need to exceed Mr. Market’s expectations for them by more than the US market does.
Will the economic factors in international and US markets exceed or fall short of Mr. Market’s expectations next year? No one knows. That’s why it is advisable to hold significant investments in both US and international stocks. The markets do their best to price in all the differences between US and international markets, but the future is impossible to predict.
The information contained herein does not constitute investment advice or a solicitation. This article is for dissemination of general information only. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. Investments are not guaranteed and are subject to investment risk, including possible loss of the principal amount invested. Past performance is no guarantee of future results.
