Are International Stocks Too Cheap to Ignore?

International stocks are on sale, but don’t pull out your wallet just yet.

As shown in the LPL Chart of the Day, International Stocks Carry Lower Valuations, both international developed and emerging market (EM) equities carry lower valuations than the S&P 500 Index, based on forward price-to-earnings ratios (PE). Global stocks’ discounts to U.S. stock valuations are larger on average than they have been historically.

 

“International developed-market equities are cheap for a reason,” said LPL Chief Investment Strategist John Lynch. “In aggregate, those companies have carried lower returns on equity and offer less exposure to what have been the fastest areas of the global equity markets that investors have favored during this bull market.”

U.S. stocks boast higher profitability per share that warrants a higher price tag. S&P 500 companies, in the trailing 12 months through Jun 30th, 2019, have generated a return on equity of 17% currently, compared with 10.7% for the MSCI EAFE Index (a stock market index representing most of Europe, Japan and the Far East) developed market constituents, and 12% for companies in the MSCI EM Index. Return on equity is a measure of the profits a company generates relative to its outstanding equity. Simply put, U.S. equity investors essentially have had a claim to more profits for the shares they own.

A different sector mix accounts for some of the disparity in profitability. The technology sector, which represents more than 21% of the S&P 500 and just 6.7% of the MSCI EAFE Index, is a dramatic difference. Technology companies have typically generated higher profit margins and returns on equity than most other sectors, giving the United States an advantage.

The MSCI EAFE Index also has much more exposure to the traditional value sectors (financials, energy, materials) and the slower-growth consumer staples sector that have underperformed in recent years. These factors have contributed to faster earnings growth for the S&P 500 than the EAFE in 8 of the past 10 years. And based on FactSet consensus estimates, the United States is expected to make it 9 of 11 years this year—and 10 of 12 in 2021.

While a 20% discount for international developed-market equities might look enticing, keep in mind that most of that discount is attributable to low valuations in Japan. The MSCI Japan Index is trading more than 40% below its 25-year average forward PE, compared to Europe, which is trading 10% above its average.

From a tactical perspective, over the next 6 to 12 months, we continue to favor U.S. equities among developed global markets for the relatively better economic, profitability, and growth profiles. Our concerns about economic growth, global policies, and interest rates translate into our preference for EM stocks over international developed-market stocks. Fiscal deficits, populism, and exhausted monetary policies could weigh on sentiment, spending, and investment throughout Europe, while structural reforms and the looming VAT increase may pressure sentiment in Japan.

 

IMPORTANT DISCLOSURES

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. The economic forecasts set forth in this material may not develop as predicted.

All indexes are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. All performance referenced is historical and is no guarantee of future results.

Investing in foreign and emerging markets securities involves special additional risks. These risks include, but are not limited to, currency risk, geopolitical risk, and risk associated with varying accounting standards. Investing in emerging markets may accentuate these risks.

Because of their narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

The P/E ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower PE ratio.

Forward Price To Earnings (Forward P/E) is a measure of the price-to-earnings ratio (P/E) using forecasted earnings for the P/E calculation. Earnings used are just an estimate and are not as reliable as current earnings data. The forecasted earnings used in the formula can either be for the next 12 months or for the next full-year fiscal period.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.

This Research material was prepared by LPL Financial, LLC.

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