What history tells us about the future performance of international stocks

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Many retirees are giving up international stocks. Is that a good idea? One argument in favor of giving up is that the large-cap stocks that dominate the US stock market have diversified globally, so a “national” index such as the S&P 500 SPX, + 1, 18% in fact already represents a healthy allocation to -US Markets. Today, for example, about a third of the revenue for S&P 500 companies comes from outside the US, and in some recent years that share has exceeded 40%.

Another reason many are moving forward to forego international stocks is that the category has been such a disappointing performance in recent years. Over the past decade, for example, the S&P 500 has produced an annualized total return of 13.7%, almost three times the 5.4% annualized total return of the MSCI Europe, Australasia and Far East Index (EAFE). However, giving up international equities may be premature. It could just as easily be argued that because US stocks have become so overvalued relative to global stock markets, their expected future returns are now among the lowest. Consider the cyclically adjusted P / E (or CAPE) ratio made famous by Yale professor Robert Shiller. The US CAPE is currently higher than any of the equity markets of 25 other developed nations. Unless global equity markets have changed permanently, therefore, it could be dangerous to extrapolate the recent past to the future. The four most dangerous words on Wall Street, as we all know, are “this time is different.” For this column, I have looked at the relative returns of the S&P 500 and the EAFE index up to when the EAFE was created in 1969. My implicit assumption in conducting this analysis is that past decades are just as relevant as more recent ones. . The attached chart reports what I found. I created six hypothetical portfolios that only differed based on allocations relative to the S&P 500 and the EAFE index. At one extreme was a portfolio that was assigned 100% to the S&P 500 and 0% to the EAFE, and at the opposite end was another portfolio that was assigned 0% to the S&P 500 and 100% to the EAFE. There were four additional portfolios with different relative allocations between these two extremes.

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Focus first on the blue bars, which reflect the annualized returns of these six portfolios. Notice their remarkable consistency: when rounded to the nearest whole percentage point, they all produced 12% annualized returns. Assuming the future is like the past, this means that the long-term performance of your equity portfolio will not change much depending on how much or how much you allocate to international stocks. However, that’s not the end of the story, as improving returns is just one reason to divide your portfolio of stocks between these two categories. Another is to reduce risk, of course. Since national and international stocks are not perfectly correlated with each other, a portfolio diversified between the two should have less volatility than one fully assigned to one or the other. However, this is only partially true. The three portfolios that had 60% or more allocated to international stocks were more volatile than the other three that had 40% or less allocated internationally. The portfolio that presented the lowest volatility risk was the one that assigned 80% to the S&P 500 and 20% to the EAFE. As a result, the Sharpe index for this portfolio, a measure of risk-adjusted performance, was the highest of the six. If we were forced to extract an investment implication, we would conclude that you should allocate 20% of your equity portfolio to non-US equities. However, when reflecting on this investment implication, it is helpful to remember the joke about how to tell if an economist has a sense of humor. The answer: use decimal points. This joke serves as a fun but important reminder that it is all too easy to succumb to false precision. Consider the degree to which the 80% domestic / 20% international portfolio outperforms the 60% / 40% portfolio. The Sharpe index for the former is 0.73, compared to 0.71 for the latter. Since the difference between these two is so small, and since there is so much noise in the data, a statistician could not, with a 95% confidence level, conclude that the 80% / 20% portfolio was a better interpreter. This will have implications when we discuss the other important finding of my analysis. Regression to the mean A corollary to my findings may not be immediately obvious. But the remarkable consistency in the returns of my six portfolios means that periods of higher performance of the S&P 500 over the EAFE are often followed by periods of lower performance, and vice versa. I quantified this by calculating the correlation coefficient between the performance of the S&P 500 relative to the EAFE over the past 10 years and its relative performance over the next 10 years. The correlation coefficient ranges from a theoretical maximum of 1 (when the two series move up and down in perfect sync with each other) to a minimum of minus 1 (when the two move perfectly inversely with each other). For these two data series, the coefficient is minus 0.53, which is statistically quite significant. What this means, assuming the future will be like the past: Because the S&P 500 outperformed the EAFE so much over the past decade, it will most likely underperform in the next decade. The implication for investors today is the opposite: Far from canceling international stocks due to their underperformance over the past decade, you may want to overweight them in the future. This investment implication becomes especially compelling in light of what I mentioned earlier about the small performance differences between my hypothetical portfolios. The bottom line? In no way should you give up international equities. And you may even want to gain weight in the future. Mark Hulbert is a regular contributor to MarketWatch. Your Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.