By Dan Weil 

Foreign stocks have had a rough go of it compared with U.S. stocks over the past decade. That might be about to change.

Stocks in foreign developed markets as well as emerging markets have greatly underperformed U.S. shares for years, pushing U.S. stock valuations far above foreign valuations. Even last year, when stocks were strong world-wide, the average U.S.-stock mutual fund or exchange-traded fund rose 28%, outpacing the average international-stock fund's 23% advance, according to Refinitiv Lipper data. This year, U.S.-stock funds were down 2.1% on average through July and international-stock funds were down 5.5%.

Now, the question is whether valuations, along with shifting global economic fundamentals, make foreign stocks an attractive investment -- perhaps finally justifying the long-held advice that U.S. investors keep at least a portion of their portfolios in overseas shares or funds. Many investing professionals say the answer to that question is yes.

"If you're investing for the next 10 years, valuations are compelling to invest overseas," says Steven Violin, a portfolio manager at F.L.Putnam Investment Management Co. in Wellesley, Mass.

In the 10 years through July 31, the S&P 500 returned 13.84% annualized, including dividends. That compares with 5.3%, in dollar terms, for the MSCI World ex-USA Index of developed nations and 3.69%, in dollar terms, for the MSCI Emerging Markets Index.

That has kept U.S. stock valuations at the top of the totem pole. As of July 31, the forward price-earnings ratio, based on earnings estimates for the current fiscal year, totaled 23.84 for the S&P 500, 18.57 for the MSCI World ex-USA Index and 15.84 for the MSCI Emerging Markets Index, according to Morningstar Direct.

On the economic front, many countries are further along than the U.S. in emerging from coronavirus lockdowns. That has helped put some of their economies in a stronger position than the U.S., many investing pros say. Numerous countries also have adopted successful economic-stimulus plans.

Those perceived economic advantages show up in earnings forecasts. Analysts polled by FactSet predict earnings for companies in the MSCI Emerging Markets Index will fall less than earnings for companies in the U.S. S&P 500 index this year. And emerging-markets earnings are seen rebounding more than U.S. earnings next year.

Those analysts also estimate earnings for developed-markets companies in the MSCI World ex-USA Index will drop more this year than for companies in the S&P 500 -- but developed-markets earnings are seen bouncing back further than U.S. profits next year.

Emerging-markets interest

Some investment managers are particularly enthusiastic about emerging markets, where stocks already have outperformed their U.S. counterparts over the past three months.

"With a long-term view of where the world's growth is likely to emanate from, emerging markets is where you might like to place your bets," says Karim Ahamed, a financial adviser at Cerity Partners in Chicago. "They have young and vibrant economies, growing faster than developed markets."

The labor pools of emerging-markets countries should grow faster than those of developed nations -- providing fuel for economic growth -- because emerging-markets nations have younger populations than developed countries, he notes.

On the pandemic front, a number of emerging-markets countries have done well fighting Covid-19. "South Korea is the gold standard," says Amanda Agati, chief investment strategist for PNC Financial Services Group. "This is a tailwind for emerging markets, though not every country has been perfect."

Economic-growth numbers are stronger for important emerging markets, such as China, than for the U.S. The International Monetary Fund estimates that U.S. GDP will contract 8% this year, compared with a 3% contraction, on average, for emerging markets. Next year, the IMF expects a 4.5% rebound in the U.S., compared with a 5.9% bounceback, on average, in emerging markets.

Many developed countries, as well, are ahead of the U.S. in the coronavirus cycle. "We're seeing signs of a potential second wave in countries like Spain and France," Ms. Agati says. "But they've already proven they can deal with a temporary shutdown, whereas the U.S. is still struggling with that initial wave."

Many investment pros are impressed with the European Union's ability to craft a EUR750 billion ($880 billion) fiscal stimulus package, passed last month. In the U.S., by contrast, Democrats and Republicans have been unable to agree on another round of stimulus that most analysts think is needed to buoy the economy.

While the IMF predicts GDP will shrink more in the euro area than in the U.S. this year -- 10.2% to 8% -- it sees a bigger recovery for the euro area than for the U.S. next year -- 6% to 4.5%.

Another factor that could help foreign stocks is the dollar's weakness. The Bloomberg Spot Dollar Index slid 9% from its March 23 high through July 31. A sliding dollar makes foreign stocks more attractive for U.S. investors because foreign stocks gain value in dollar terms when the dollar is falling.

Market psychology

Psychology will also play a role in lifting foreign stocks compared with U.S. stocks, says Jeffrey Kleintop, chief global investment strategist at Charles Schwab. "It's almost more behavioral than fundamental," he says. "After a decade, whatever markets led in investor expectations get high in value, and then recession resets expectations. Where expectations were highest, valuations come down the most."

Market history has played out that way for the past 50 years, with the direction of U.S. and foreign markets flipping at the end of every economic cycle, which often last about 10 years, Mr. Kleintop says. So he anticipates foreign stocks will outpace U.S. shares for the next decade.

"There may be real value in Asian and European companies that serve the same customer base as U.S. companies but can be purchased for a lower cost," he says.

Allocation strategy

So how should investors interested in foreign stocks allocate their money? A broad, diversified exposure to countries and industries gives investors a chance to participate in the upside of foreign stocks while potentially damping declines, analysts say.

"You don't need to get fancy," Mr. Kleintop says. He figures that including one broad exchange-traded fund for developed markets and one for emerging markets in a portfolio would do the trick. That would give investors a chance to tweak their weighting between the two, as emerging-markets stocks often outperform developed-markets stocks early in the economic cycle before lagging later, he says.

The two biggest developed-markets ETFs are Vanguard FTSE Developed Markets ETF (VEA) and iShares Core MSCI EAFE ETF (IEFA). Both funds receive Morningstar's top rating of gold.

The two biggest emerging-markets ETFs are Vanguard FTSE Emerging Markets ETF (VWO) and iShares Core MSCI Emerging Markets ETF (IEMG). Both have Morningstar's third-highest rating of bronze.

While broad ETFs offer a convenient, inexpensive option, Mr. Ahamed of Cerity Partners says a good active manager can provide more downside protection. He recommends a combination of active and passive funds.

One active mutual fund Mr. Ahamed likes is Harding Loevner Emerging Markets Advisor (HLEMX), rated silver by Morningstar. "It's conservative: quality with a growth bias," he says. "It's a one-stop solution."

One issue investors face when venturing overseas is whether to hedge their currency exposure. That exposure helps when the dollar is falling -- but hurts when the dollar is rising, as foreign holdings are then worth less in dollars.

Many experts recommend against hedging, because exposure to foreign currencies diversifies a portfolio, and hedging can be expensive, especially for emerging-markets currencies. "If you're a long-term investor, being unhedged makes sense," Mr. Ahamed says.

Either way, it's high time to consider foreign stocks, many experts say. "Most investors faced with challenges retreat to what has worked -- leaders of the last cycle," Mr. Kleintop says. "That's the wrong instinct. Rebalancing now [toward foreign stocks] is more important than anytime in the last decade."

Mr. Weil is a writer in West Palm Beach, Fla. He can be reached at reports@wsj.com.

(END) Dow Jones Newswires

August 09, 2020 22:14 ET (02:14 GMT)

Copyright (c) 2020 Dow Jones & Company, Inc.