Owning non-U.S. stocks has been a terrible move — and that’s exactly why you should keep holding them

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Will international stocks ever outperform the US market again? It’s worth asking given the disappointing results for non-US stocks in 2021 — the fourth year in a row in which they outperformed their US counterparts.

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On average last year, non-U.S. stocks gave gains of 8.3% (as seen by the Vanguard FTSE All-World ex-US index fund VEU,
-0.05%
In contrast, the US stock market outperformed, gaining 25.7% (as seen by the Vanguard Total Stock Market ETF VTI),
+0.04%
,

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While this is certainly disappointing for investors who have diversified their stock holdings to include non-U.S. stocks, the fundamental case for such diversification is as strong as ever — if not stronger.

US dollar fortune

Perhaps the strongest single factor in explaining the relative performance of US and non-US stocks is the value of the US dollar relative to foreign currencies. A weaker dollar helps the dollar-denominated performance of non-U.S. stocks, while a stronger dollar does just the opposite.

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Consider the four calendar years since 2009 in which the United States Dollar Index DXY,
+0.40%
refused. On average, non-U.S. stocks outperformed U.S. stocks by 1.9 percentage points over those four years (as determined by the two exchange-traded funds mentioned above). In contrast, in the nine calendar years since 2009 in which the dollar index rose, non-U.S. stocks lagged behind U.S. equities by an average of 11.7 percentage points.

Given this strong inverse correlation between the US dollar and non-US equities, investors in non-US stocks should focus on when the dollar will fall. Only if you believe the dollar has reached a permanently high level from which it will never fall, will you be justified in reducing your international equity exposure. But such belief is absurd: Forex exchange is a free market, like the stock and bond markets. Nothing that is traded in these markets ever goes down.

value vs growth

There is another factor that is currently influencing the relative performance of US and non-US stocks: where markets tend to swing the pendulum between price and growth. Although price has outperformed growth over the past century, on average, the last decade has been a stark exception to that pattern. US stocks have benefited greatly from this exception. Only if you believe this exception will continue will you wish to reduce your holdings of non-US stocks.

One way to put this price-versus-growth dimension into context is to compare the CAPE ratio of US and non-US stocks. The CAPE ratio is the “cyclically adjusted price/earnings” ratio made famous by Yale University professor Robert Schiller. It has historically had the best track record in interpreting and predicting stock market returns for the next 10 years. And, despite claims that it has lost its explanatory power, it has as good a track record over the past few decades as it did before.

As you can see from the chart below, the US currently has the highest CAPE ratio of any developed country – much higher in fact. Europe’s CAPE is currently in the low 20, compared to the US’s ratio in the high 30. The United Kingdom is in the high teens. Unless the stock market has permanently severed its relationship to corporate earnings, the stock markets in these other countries should eventually outperform the US market.

When they do, you’ll be glad you’ve got hold of your international shares, as many are currently doing, throwing in the towel and limiting your equity holdings to US stocks only. .

Mark Hulbert is a regular contributor to Businesshala. Their Hulbert Ratings track investment newsletters that pay a flat fee to be audited. he can be reached here [email protected]

more: Value stocks are now beating growth by 10 points, but easy money may be behind us

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