After a multi-year bull run, U.S. equities are fairly valued if not overpriced and are beginning to slow. On the other hand, international stocks and exchange traded funds may offer better opportunities going forward.
On the recent webcast, Sourcing Growth in a Growth-Starved World, Ted Lucas, Managing Partner and Investment Committee Chairman for Lattice Strategies, explained that U.S. stocks show less favorable valuations with headwinds ahead.
“Our research shows that the fertile conditions of past bull markets – low starting valuations, poor fundamentals and double-digit starting yields – have reversed,” Lucas said.
For instance, back in 1982, the S&P 500 index showed a price-to-earnings multiple of 7.7 times, whereas the benchmark was trading at a P/E of 18.5 times in October 2015. Meanwhile, the cyclically adjusted P/E multiple, or CAPE ratio, shows an even wider divergence, with a 7.4 times reading in 1982, compared to 24.6 times two months ago.
Moreover, historical data also shows that P/E levels typically rise after interest rates fall, and vice versa. With the Federal Reserve largely expected to hike interest rates ahead, we may see lower growth.
“Record-low interest rates and above-average P/E levels pose a very real challenge to long-term returns,” Lucas said.
Alternatively, Lucas pointed to developed markets outside the U.S. and emerging markets that are more attractively priced. For example, developed markets ex-U.S. show a 14 CAPE reading or slightly above the historical lows of 11, and the emerging markets have a 11 CAPE reading, which is their historical low level. In contrast, U.S. stock CAPE readings are in the mid-level of their historical range.
“There are more fertile opportunities for long-term growth in developed ex-U.S. and emerging markets equities,” Lucas added.
Overseas investments, though, are not without their risks. For instance, currency volatility, high debt-to-GDP, country concetnrations and political risks, among others, are some risks that investors should keep in mind.
Nevertheless, Darek Wojnar, Managing Director and Investment Committee Member for Lattice Strategies, believes investors can diminish investment risks through factor-based investment strategies.
For instance, Lattice Strategies offers three separate smart-beta index-based ETFs, including the Lattice Developed Markets (ex-US) Strategy ETF (NYSEArca: RODM), Lattice Emerging Market Strategy ETF (NYSEArca: ROAM) and Lattice Global Small Cap Strategy ETF (NYSEArca: ROGS).
Specifically, the smart-beta ETFs try to improve risk and return potential by focusing on deliberate risk allocation, diversification and enhanced return potential. The underlying benchmarks try to limit volatility and drawdown risk. The ETFs may also offer greater diversification benefits by de-concentrating country, currency and individual company risks. Lastly, the funds can generate better risk-adjusted returns by focusing on companies with improved value, momentum and quality.
Through the indexing methodology, the Lattice ETFs may help improve diversification and potentially enhance returns relative to traditional market cap-weighted index funds. For instance, RODM has smaller country tilts toward major developed markets like Japan, U.K., France and Switzerland than traditional EAFE Index funds and also includes a 11.2% tilt toward Canada. ROAM intentionally de-emphasizes China, South Korea and Taiwan – some of the largest country tilts in major emerging markets indices – and reallocates toward countries in the earlier phases of growth.
Furthermore, due to their alternative indexing methodologies, RODM and ROAM would both have a greater value tilts and cheaper valuations than traditional benchmarks. Specifically, RODM shows a 1.46 price-to-book and 13.05 price-to-earnings, whereas cap-weighted indices have a 1.53 P/B and 16.35 P/E. ROAM has a 1.25 P/B and a 9.78 P/E, compared to cap-weighted benchmarks’ 1.26 P/B and 11.57 P/E.
Financial advisors who are interested in learning more about investing in international markets can listen to the webcast here on demand.