U.S. stocks have always enjoyed premium valuations compared to their international peers. But, as we pointed out in a recent research note, the divergence between U.S. and foreign stocks has grown to record levels this year. This has caused a number of analysts to worry about a potential downward correction, a risk we highlighted as worthy of consideration.
With U.S. stocks looking expensive, could that mean there is an opportunity in international stocks? Possibly, but not necessarily.
Cheap or just cheaper?
While it might seem as if the comparatively better performance of U.S. stocks during the present bull market is a sign of trouble ahead, this is not necessarily the case. Indeed, lagging performance among global stocks might be what is to blame for the increasing divergence, not overexuberance in U.S. stocks. While there might be legitimate concerns that the U.S. stock market has diverged materially from its own underlying domestic economy, there is also evidence of unprecedented economic strength at home and abroad.
Thus, when looking at foreign stocks as they compare to U.S. stocks, the first question we must answer is this: Are foreign stocks legitimately undervalued, or are U.S. stocks just overvalued?
At first glance, international stocks look to be far from beaten down price-wise. Like U.S. stocks, they have enjoyed growth during this bull market expansion. So it may be a case of foreign stocks not so much cheap in themselves (and thus a buying opportunity), but simply less extremely overvalued than U.S. stocks.
The convergence trade
On the other hand, the aforementioned global economic strength may support the case for foreign undervaluation rather than U.S. overvaluation. According to research by the Heisenberg Report, there may be a great opportunity at hand for a “convergence trade”:
Key to the convergence trade is the notion that outperformance by ex-U.S. assets is not only not bearish for U.S. stocks, but in fact the best possible outcome for U.S. equity bulls who believe the performance disparity between their positions and foreign assets is no longer sustainable.
If you think the divergence between U.S. stocks and the rest of the world is untenable, but you want to remain bullish on the former, well then you want the convergence trade to play out with ex-U.S. assets rallying to close the gap, rather than the alternative, which is U.S. stocks selling off and 'catching down' (if you will), to what would in retrospect be seen as the international 'reality.'"
In the simplest possible terms, the idea is that if the rest of the world rallies, it will reduce spillover risk for the U.S. market. Because the fundamentals in the U.S. have rarely (if ever) been better, the only impediment to new highs is the possibility that international turmoil will boomerang back to Wall Street. If you remove that impediment (i.e., if international assets rally), U.S. stocks will be free to make new record highs, even if the pace of the gains lags that seen in ex-U.S. stocks.
According to this line of thinking, convergence will mean that foreign stocks rise to meet economic realities, rather than U.S. stocks getting pulled down. There is definitely something to this line of thinking. It shows that valuations both within and across countries are not so clear-cut as they might at first appear to be.
Verdict
There may be opportunities in foreign stocks if they are to converge to the upside. In such a case, it may be worth investors’ time to look beyond America’s shores to find opportunities in the stock markets that have been anemic despite their underlying economic growth. It is also important to acknowledge that international stocks carry their own risks and opportunities and should not be plunged into just because they look somewhat cheap. It is a bad idea to jump into any unfamiliar market without knowing what the waters are like.
There may also be something to the case that continued economic strength will act as a driver for rising stock prices at home and abroad. But we caution on this view. While it is true that simply diverging from historical valuations is not in itself a definitive sign of trouble, it is still an indicator that demands attention.
We are moving in a market of rarefied prices. Investors should act with great caution when playing macro factors given that environment.
