In recent commentary, I provided a variety of reasons for diversifying abroad. And the evidence continues to pile up. The trailing 5-year P/E for the MSCI World ex USA Index traded at 27 back in October of 2007; it trades at 19 here in May of 2014 at a 17.4% discount to U.S. equities. Other research has been even more unfriendly to the idea that U.S. stocks are a “buy.” Research Affilliates, a firm in my neck of the woods in Orange County, CA, explains that the U.S. market is approximately 60% above its average long-term P/E. Meanwhile, countries like Brazil, China and South Korea all trade at a 20% discount to their own long-term P/Es.
In essence, it may be time to question the prevailing wisdom that one should invest in U.S. stocks because its economy represents the “cleanest dirty shirt in the laundry bin.” Stock assets from cleaner, safer economies may deserve a premium when their central banks are heavily engaged in stimulating and supporting growth. However, when a number of technical chart patterns and fundamental data demonstrate stark contrasts between foreign and domestic stocks, the so-called “clean shirt” premium may evaporate.
After three years of relative weakness, I believe foreign stocks and a number of emerging markets will outperform. Investors are beginning to see bargains. They are warming up to the possibility of government/central bank-led economic support abroad. And they are growing wary of dedicating so many eggs to the domestic basket.
In the beginning of the year, I felt strongly about country funds like iShares MSCI New Zealand (ENZL). More recently, I I have added capital to country funds like iShares MSCI South Korea (EWY) and regional funds like iShares All-Country Asia ex Japan (AAXJ).
Granted, the prospects for further deterioration in Chinese real estate present risks to the mainland and its neighbors. On the other hand, fundamental value and technical price patterns suggest that a whole lot of the trouble may have been priced in over the last three years. Getting AAXJ for the same price as one might have paid three years earlier is a reasonable risk, particularly when one understands how to use stop-limit loss orders to protect against unfavorable outcomes.