American equities blew past the rest of the world last year. But nothing stays the same in investing, and offshore exposure is good for diversification. So we consulted market experts Nicholas Atkeson and Andrew Houghton, who are the founders of Delta Investment Management in San Francisco, for insight about offshore equities:
Light: What’s the history on this question?
Houghton: The U.S. stock market, that is the S&P 500, has dramatically outperformed both international developed and emerging markets since the start of 2009. During the first 10 years of the 21st century, international markets enjoyed multi-year periods of outperformance relative to the S&P 500. Some of the underperformance of the past decade is a normalization of outperformance in the prior decade.
Atkeson: The United States stock market represents 54% of the world’s total equities value even though the U.S. population represents only 4.3% of the world’s population. According to the Brookings Institute, over half of the 7.7 billion people in the world today are either “middle class” or “rich.” In the next 10 years, the global middle class is expected to grow from 4 billion people to 5.3 billion.
The price-to-book ratio for the MSCI Emerging Markets Index is 1.7 times. This is below its 20-year average of 1.8. There is a strong correlation between book value and subsequent five year returns in the emerging markets. At a P/B ratio of 1.7 times, the best fit line suggests average annual returns of 12.5% in U.S. dollars for the next five years. Actual outcomes may vary significantly and the historic range of outcomes is quite wide.
The price-to-book ratio of the S&P 500 is currently about 3.4 times, which is higher than the 25-year average of 3 times.
Light: What should you do about international investing?
Atkeson: If you have been concentrating your stock investments in the U.S. markets over the past 10 years and you are having trouble finding attractively valued securities in the U.S. stock market today, 2020 may be a year when you take steps to increase your global stock diversification. Year-to-date, emerging market equities are leading the world equity markets higher.
Houghton: Europe is showing strength. Germany, Italy and France have been in the top five best performing stock markets for the past three months. If we isolate just European stock markets using the STOXX 600 index, Europe may finally be setting up for a sustained upside breakout.
After 12 years of failing to trade significantly higher than the 2007 peak, an upside breakout in European stock markets may represent a major step forward. It appears that the region’s zero-to-negative interest rates and €20 billion worth of monthly bond buying, known as quantitative easing or QE, is having effect. It suggests the possibility of recession globally is becoming more remote. It suggests that the U.S. stock market may see renewed vigor in its step as the global economy is more integrated than ever.
Light: What do earnings tell us?
Atkeson: The S&P 500 consensus earnings estimate for 2020 is $178, a 10% advance from the 2019 earnings of $162. The 2021 consensus earnings estimate is $197 which represents an additional 11% advance above the 2020 estimate. What is most encouraging about earnings estimates is after being revised lower for the past twelve months, we are beginning to see upward revisions.
Light: And fund flows?
Houghton: In the next several weeks, we will see if the economy remains on a steady growth path and if earnings projections hold up. Although the stock market is near all-time highs, $61 billion was withdrawn from U.S. mutual funds and ETFs in 2019. This is the largest negative annual fund flow amount this century by a factor of two. Fund flows into taxable bonds were a positive $251 billion.
Significant fund flows away from equities and into fixed income suggests the crowd may be more interested in a return of principal rather than a return on principal—a generally pessimistic outlook. But if we were to take the current earnings yield on Baa rated bonds at 3.9%, it implies an S&P 500 multiple of 25.8 times. Contrarian investors have reason to be optimistic.
Atkeson: Consensus earnings estimates for 2019 and 2020 have been declining for the past year. Some of the estimate decline may have been caused by trade war uncertainty. If this is the case, we may soon see earnings revisions move upward in the wake of the Phase One deal. Earnings growth in 2020 is an essential input to our positive 2020 stock market outlook.
Light: What about the Leading Economic Indicators?
Atkeson: The second concern we have is the LEI has been mixed, positive and negative, since last October and is not improving in conjunction with recent stock market appreciation. The November LEI was reported at 0.0%.
When the six-month moving average of the month-to-month percent change in the LEI turns negative, we see this as a recession signal. On a preliminary basis, the six-month LEI moving average has turned negative. We say “preliminary” as the LEI report is backwardly revised for two months. It is quite possible we see upward revisions in the next report that negate the current negative reading. A consistently negative LEI would be cause for concern.
Houghton: Notice that the weakness in the LEI is predominately in manufacturing. Manufacturing is the sector most impacted by trade uncertainty. It is possible the positive advance in the China trade discussions allows the manufacturing sector to rebound. The LEI reported strength in residential construction, financial markets and consumer expectations, all of which are significant positive drivers of GDP growth.
Patience is a virtue in investing. Like the uncertain earnings outlook, we will have to wait and see how the LEI changes over the next couple of months before we decide if our worries should become actionable. We ended last year invested in equities and hopeful that the surprises we see in the New Year are positive rather than negative.