Published on November 4, 2022 in the Rochester Business Journal

This year has been an admittedly painful one for both U.S. and international stocks. Through 9/30/22, and per MSCI Investable Market Index (IMI) data obtained through Bloomberg by Northern Trust Asset Management, U.S. equities are down 24.7%, emerging international equities are down 26.5% and developed international equities (ex-U.S.) are down 26.6%. While all parts of the equity market appear to be down in tandem and by approximately the same amount, a closer look at the relative valuation in each IMI as well as the historic reversals between U.S. and international equity market outperformance may provide insight on the potential rewards available to those who are patient enough to wait, particularly in developed international markets.

In the U.S., the MSCI IMI represents 2,588 constituents, covering approximately 99% of the free float-adjusted market cap of small, mid-size, and large U.S. companies – broad, but representing only one country. MSCIs Emerging International IMI consists of approximately 3,210 companies in 24 countries including China, India, Taiwan, South Korea, Brazil, South Africa, Mexico, Indonesia, Thailand, and Malaysia, among others. Finally, the MSCI Developed International IMI includes 22 developed countries including Japan, U.K., Canada, Switzerland, France, Australia, Germany, Netherlands, Sweden, and Denmark.

Although, collectively, the stocks in each of these IMIs have fallen by approximately the same amount through September of this year, valuations in each area are much different, when considered in relation to the earnings that are expected from the underlying companies in each over the coming twelve-month period. For example, in the U.S. and despite the 24.7% drawdown in stock prices through the end of September, U.S. equities are still no grand bargain and can best be described as fairly-valued – that is to say that current U.S. stock prices (cumulatively) were 15.6 times the earnings expected from the companies in that IMI over the next twelve month period, which was nearly the same as the long-term median (i.e. middlemost) forward price-to-earnings (P/E) multiple of 15.7 times, based on data going back to 1970.

Relative valuation is a bit more interesting in the emerging international markets and as measured by forward P/E. In this IMI, stocks were priced at 10.2 times next year’s earnings at 9/30/22, versus a long-term median forward P/E of 11.3. A forward P/E of 10.2 falls somewhere between the median and the low of where forward P/Es have historically fallen two-thirds of the time since 1995, based on calculations at the end of each month throughout the period. In this context and if history is any guide, emerging market stocks can be thought of as being somewhere between fairly-valued and undervalued.

In Developed International Markets (ex-U.S.), relative valuation is even more intriguing. Here, the forward P/E of the companies contained in this IMI amounted to 11.0 at 9/30/22, versus a long-term median forward P/E of 13.9. At this level, the collective relative value of developed international stocks was not only below its long-term historic median, but also well below the range of forward P/Es that have been captured in this area two-thirds of the time since 1970, suggesting that developed international stocks are clearly undervalued, if history is any guide.

To a large degree, valuations reflect the current situation in each IMI and the investment opportunities investors perceive there on a more immediate basis. Stocks become cheap when noone wants to own them and when the current situation and/or outlook is poor. That said, situations can and do change, and when they do, investors stand to reap most of the rewards by being invested there early. This perfectly describes the prospect of being invested in international markets today, and specifically the developed international markets.

Based on relative valuation alone, we could argue that international stocks are a better buy than U.S. stocks. We could also argue that international stocks may be poised to outperform U.S. stocks in the not-too-distant future, based on data collected from FactSet and MSCI, and as presented by J.P. Morgan Asset Management in their Q322 Guide to the Markets. In this publication, J.P. Morgan looks at periods of U.S. equity market outperformance versus periods of international equity market outperformance, as measured by the MSCI US and MSCI EAFE (Europe/AustralAsia/Far East) indices, going back to the early 1970s. It tracks the number of years the relative outperformance lasted and the cumulative outperformance (in percentage terms) that resulted during each period.

At 9/30/22, the data in J.P. Morgan’s Q322 Guide to the Markets shows that U.S. stocks have been outperforming international stocks for the last 15 years, resulting in cumulative outperformance of 210% during that period. The data also suggests that this is the longest streak of U.S. versus international outperformance that has taken place over the last 50 years - the next longest period was only 7.3 years and favored international stocks. Market leadership between domestic and international stocks (i.e. sustained outperformance of one over the other for at least a 12-month period) has changed hands at least nine or ten times since 1970, so not only are international stocks cheaper than U.S. stocks on a relative basis, but they seem to be due for a period of outperformance.

Noone knows when international stocks will begin to outperform U.S. stocks, but few would argue that they shouldn’t be included in a well-diversified investment portfolio, regardless of when that day might come. Waiting until current conditions improve to add them (or add more of them) to your portfolio risks missing out on a substantial portion of the rewards you’re likely to reap – history suggests that if you miss out on just a few of the best performing trading days of the year, you typically miss out on most of the year’s returns.

Buying parts of the market when they’re out of favor (i.e. cheap on a relative basis) and assuming that reversals of U.S. versus international equity market outperformance will continue seem like rational propositions, particularly as they relate to the diversification of your portfolio and its risk-adjusted return. Investing in international markets may require patience, but it can lead to out-sized rewards for those able and/or willing enough to wait.

To see this column in the RBJ, click here.