Does Global Diversification Still Make Sense?
One of the recurring themes of the 2010s decade extending into 2020 has been the robust outperformance of U.S. equities vs. international developed and emerging market equities. For the 11-year period ending 12/31/2020, the average annualized return of the U.S. market (as represented by the Russell 3000 Index) exceeded international developed (MSCI EAFE Index) by 8.4% and emerging markets (MSCI Emerging Markets Index) by 9.2%. In only two of these eleven years did international prevail over the U.S.
Undoubtedly, foreign equities have provided a challenge to U.S. investors who may view them as an albatross around the neck of their portfolio. Indeed, they could be forgiven for questioning the benefits of global diversification. However, we would consider it a grave error for them to dump their non-U.S. stocks based on disappointing past performance.
Our friends at Vanguard recently completed a study entitled “A Tale of Two Decades for U.S. and non-U.S. equity: Past is Rarely Prologue.” They found that about 60% of the U.S. outperformance was explained by changes in valuation—investors are now willing to pay significantly more for a dollar of U.S. earnings than non-U.S. earnings. The remaining 40% is about evenly split between earnings growth (U.S. grew faster) and appreciation of the dollar. The only tailwind propelling foreign stocks was a 1.1% higher dividend yield.
A fair question to ask is what do we expect to happen with these factors over the long-term? The easiest one to answer is the dividend yield where Vanguard Total International Index (VTIAX) leads the Vanguard Total U.S. Stock Market Index (VTSAX) by 0.9%, so no significant difference there.
Regarding change in valuations, U.S. equities are already at historically high price-to-cyclically-adjusted earnings levels, as the only time they have been higher was in the run-up to the dot-com crash in the early 2000s. International equities are currently below their historical average levels. Thus, it is quite unlikely that the next decade will repeat the divergence of the prior one.
For earnings growth, the important factor is not the growth itself but the growth relative to the market’s expectations. We find no compelling reason to believe that the market has either underestimated U.S. growth or overestimated foreign growth.
Finally, the future of the dollar, as usual, is completely unpredictable other than what we observe in the currency forward markets which are already reflected in current prices.
The Vanguard Capital Markets Model, which we rely on for financial planning purposes, unsurprisingly forecasts a reversion to the mean. For the next decade, the model expects the annualized return of non-U.S. equities to exceed U.S. equities by 3.3% with slightly higher volatility. As always, expected returns may not equate to realized returns.
Does this forecast mean investors should go all-in on non-U.S. equities? Absolutely not! For American investors, U.S. equities should continue to be the core holding of the stock portion of their portfolios. For most investors we recommend having 25 to 40% of their equities in non-U.S. stocks. Going forward, even if their returns are a little bit lower than U.S. stocks, they will still provide beneficial diversification. And if they capture higher returns, so much the better.
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