As our regular readers are aware, we’ve been pounding the table all year arguing that foreign stocks are in a position to structurally outperform domestic stocks. At the risk of sounding like a broken record, we thought we would – in one post – review the setup that makes foreign equities relatively attractive at this juncture.

1) US stocks have outperformed foreign stocks almost continually since 2008 – nothing lasts forever

In our world there are only three different kinds of trades:

  1. Momentum trades – trades that try to exploit price momentum and the herding behavior observed in markets
  2. Carry trades – trades that seek to capitalize on interest rate differentials between assets
  3. Return to the mean trades – trades that benefit from mean reversion of returns between assets

The opportunity for investors to increase their international equity exposure at the expense of domestic equity exposure is a return to the mean trade. The essence of a return to the mean trade is that in the fullness of time two similar assets should have a similar return. Since the end of 2007 the United States has outperformed DM EMEA by 45%, DM Asia by 38%, and EMs by 48%. One can argue that there were structural reasons for the lopsided returns over the last decade, but even structural divergences don’t last forever. And indeed, it looks like foreign markets have stopped underperforming. Relative performance for DM EMEA and EMs stopped making new lows at the end of 2016 while DM Asia stopped making new relative lows at the end of 2014. The first three charts below show the relative performance of the three regional equity indexes compared to the United States index.

2) Relative valuations favor foreign equities, except in Europe

The substantial outperformance of US stocks has come with substantial relative valuation expansion, especially in developed Asia and the emerging markets. Higher valuations necessarily imply lower prospective returns, and vice versa. The charts below show the median price to book value ratio for stocks in each region compared to the median price to book value of US stocks. By this measure, relative valuations are right on the mean for DM EMEA, 11% below average for DM Asia and 22% below average for the EMs.