Every quarter, major asset management companies around the world publish their forecasts for the leading stock markets. Back in the first quarter of 2020, many of these institutions sounded very optimistic about U.S. market performance as a result of the significant sell-off in stocks.
Global markets have come a long way since then, and many equity markets seem to be overvalued. Because of this, asset managers are advising investors to be cautious when selecting investments, as bargains are not as abundant as they were in the first quarter of 2020.
What is very interesting to note is that many investment managers are forecasting foreign markets to outperform U.S. markets in the short to medium term.
The case for international investing
One of the primary reasons behind investing in foreign stocks is to enjoy the diversification benefits that come along with this strategy. There are, however, many other reasons for investors to look outside the U.S. at the moment.
First, U.S. markets have outperformed foreign stocks for more than nine years now, but the historical average is around 7.2 years per cycle, according to data from Schroders Investments. As the below chart illustrates, the outperformance of these two asset classes has been cyclical since 1975, suggesting that a rotation in favor of international equities is likely to happen sooner rather than later.
Source: Schroders
It would be impossible to predict when the change will occur, but the market will only get this information in hindsight. Therefore, the prudent strategy, in my view, is to remain invested in foreign stocks in anticipation of this change.
Second, the U.S. economy continues to feel the wrath of the Covid-19 recession while many other nations that have managed the crisis better have well and truly moved past the maximum point of suffering from an economic perspective. As the below chart illustrates, China and New Zealand are already in the expansion stage of the business cycle, and many emerging nations, including India and Brazil, are in the recovery stage. In comparison, the United States is still at the bottom of the business cycle, suggesting many other countries will report relatively high GDP growth in the coming years.
Source: Moody's Analytics
The stage of the business cycle of an economy will have a meaningful impact on the performance of equity markets, and the global business cycle map suggests U.S. markets will lag their foreign counterparts in the next few years.
Third, there's statistical evidence to suggest value investing works better in foreign markets due to them being in an earlier stage of capitalism. A quick look at the Buffett Indicator reveals that U.S. markets are in the deeply overvalued territory, and even growth stocks are expensive relative to their historical trading multiples. Even though this observation calls for a comeback from value investing strategies, there's reason to believe that the best course of action would be to invest in undervalued foreign markets. The below chart illustrates the five-year rolling returns of value and growth strategies in both American and foreign markets.
Source: Schroders
Based on all this information, it's easy to conclude that there is a strong case for investing in foreign stocks at the moment.
Performance predictions by top investment managers
Morningstar polled the largest asset managers and market research companies in the U.S. to gauge a measure of performance expectations for global equity markets, and each of these experts consulted by Morningstar expect developed foreign markets and emerging markets to outperform American markets in the next seven to 10 years.
Source: Morningstar
There is no need for U.S. investors to panic, as investing in equities is often an exercise that spans beyond just a decade. However, to generate alpha returns in the next few years, an investor can use the data in the above table to allocate assets efficiently to gain exposure to markets that are well-positioned to deliver stellar returns.
China was the only economy to grow in 2020
Investing in China is changing forever due to recent regulatory actions by U.S. policymakers. While this has created significant uncertainty regarding the outlook for U.S.-listed Chinese stocks, there is no arguing with the fact that China is well and truly making progress in becoming a global economic superpower.
China's GDP grew 2.9% in 2020, making it the only nation in the world to report positive economic growth in one of the most turbulent years the world has ever seen. Once again, this goes on to highlight the resilience of the Chinese economy and its ability to weather adverse external developments.
U.S. investors need to consider the additional risks of investing in Chinese companies that they face compared to the rest of the world, but this is not the objective of this analysis. The key point to note is that the U.S. is at a much later stage of growth than China, and this will have a major impact on the performance of stock markets in the coming years.
Building the optimal portfolio
As discussed earlier, the outperformance of U.S. and foreign markets tend to be cyclical. Unfortunately, there is no proven way to identify the inflection points, and trying to time the market is not a sustainable strategy.
Because of this reason, the best course of action would be to remain invested in both these asset classes. An active investor might want to allocate a higher-than-average weight to foreign stocks at least for the next few years as lucrative opportunities in U.S. markets are few and far between. The key to developing an optimal portfolio is to allocate assets in a way that gives the best opportunity to maximize returns while keeping the total risk of the portfolio at or below the desired risk tolerance level.
Takeaway
There is a strong case for investing in foreign stocks, and the leading investment managers in the world agree with this. Carefully identifying which markets to diversify into and allocating assets accordingly could prove to be a winning strategy in the next few years. As always, keeping a close tab on the likes of Ray Dalio (Trades, Portfolio) who have mastered the art of investing in international equities can help investors uncover opportunities that they might otherwise miss.
Disclosure: The author does not own any stocks mentioned in this article.
Read more here:
- Implications of the Proposed Tax Hikes
- Any Weakness in Netflix Is an Opportunity for Growth Investors
- How to Prepare for an Inflation Spike in 2021
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
