{"id":218411,"date":"2025-02-07T10:11:33","date_gmt":"2025-02-07T15:11:33","guid":{"rendered":"https:\/\/ibkrcampus.com\/campus\/?p=218411"},"modified":"2025-02-07T10:11:25","modified_gmt":"2025-02-07T15:11:25","slug":"is-it-time-to-ditch-international-stocks","status":"publish","type":"post","link":"https:\/\/www.interactivebrokers.com\/campus\/ibkr-quant-news\/is-it-time-to-ditch-international-stocks\/","title":{"rendered":"Is It Time to Ditch International Stocks?"},"content":{"rendered":"\n

The post \u201cIs It Time to Ditch International Stocks?\u201d first appeared on Alpha Architect<\/a> blog.<\/em><\/p>\n\n\n\n

What the video version of this blog here<\/a>.<\/em><\/p>\n\n\n\n

Raise your hand if you\u2019re tired of hearing that \u201cthis year will be the year for international investing!\u201d <\/p>\n\n\n\n

Since 2010, the S&P 500 has beaten the International Developed market in all but three years (2012, 2017 & 2022). This led the U.S. market to outperform International Developed by an astounding 8.14% compounded per year. Wowza! Talk about pain if you\u2019re a global investor.<\/p>\n\n\n\n

\"\"<\/figure>\n\n\n\n

Source: YCharts. 01\/01\/2010 \u2013 12\/31\/2024. The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index.<\/p>\n\n\n\n

So what gives? What could possibly make international investing appealing in this day and age?<\/p>\n\n\n\n

Sure, we could talk about U.S. market concentration and valuation concerns (which are real<\/a>). Or we could highlight the potential diversification benefits of investing internationally. But a more compelling question to tackle is: \u201cHow did the U.S. market actually realize its astonishing relative outperformance?\u201d The answer might offer clues about whether U.S. dominance is just inevitable or if diversifying overseas is the more attractive proposition.<\/p>\n\n\n\n

Let\u2019s dive in.<\/p>\n\n\n\n

Theoretically, a market could go up for two reasons:<\/p>\n\n\n\n

    \n
  1. Valuation repricing:<\/strong> Investors bid up prices. Even if earnings remain steady, valuations rise as demand increases.<\/li>\n\n\n\n
  2. Better-than-expected fundamentals:<\/strong> Earnings increase.<\/li>\n<\/ol>\n\n\n\n

    For international investing, there\u2019s one additional factor:<\/p>\n\n\n\n

      \n
    1. Currency Effects<\/strong>: A rising dollar is bearish for foreign investments, while a falling dollar provides a tailwind for international assets.<\/li>\n<\/ol>\n\n\n\n

      Let\u2019s examine each of these and determine how each of these affected the return gap between U.S. and international stocks.<\/p>\n\n\n\n

      Valuation repricing<\/strong><\/h2>\n\n\n\n

      When comparing U.S. outperformance to international markets, it\u2019s tempting to assume fundamentals played the\u00a0only<\/em>\u00a0role. But is that what actually happened?\u00a0<\/p>\n\n\n\n

      Let\u2019s ask the quants.<\/p>\n\n\n\n

      According to AQR\u2019s Cliff Asness, Antti Ilmanen and Dan Villalon, U.S. outperformance over international developed from 1990 through 2022 can mostly<\/em> be attributed to valuation expansion. In fact, richer valuations account for about three-quarters of the U.S.\u2019s relative outperformance over international, while the rest can be attributed to fundamentals \u2013 or maybe just pure luck! Over this time period, U.S. stocks appreciated mainly because people were willing to pay more for the same earnings, not necessarily because of superior fundamental growth.1<\/a><\/sup> Therefore, betting 100% of a portfolio on U.S. stocks is essentially a bet on unending optimism. A bold bet if you ask me!<\/p>\n\n\n\n

      \"\"<\/figure>\n\n\n\n

      Source: Asness, Cliff, Ilmanen, Antti and Villalon, Dan. \u201cInternational Diversification \u2013 Still Not Crazy After All These Years.\u201d The Journal of Portfolio Management 49, no. 6 (June 2023).
      Still, we have to give it to the U.S. I\u2019d rather have my assets appreciate through multiple expansion than not at all.<\/p>\n\n\n\n

      US 1 \u2013 International 0<\/strong><\/p>\n\n\n\n

      But I hear you. Obviously, not all<\/em> the return differential came from multiple expansion. In fact, about 1.2% of the return differential cannot be accounted for by multiple expansion. Yeah, maybe it\u2019s not statistically insignificant\u2026 But it\u2019s definitely economically significant!<\/p>\n\n\n\n

      Let\u2019s explore one plausible explanation behind this 1.2% (as noisy as it may be).<\/p>\n\n\n\n

      Earnings growth story<\/strong><\/h2>\n\n\n\n

      Multiple expansion seldom happens randomly. More often than not, fundamentals catalyze valuation revisions. So let\u2019s look at the story behind earnings growth.<\/p>\n\n\n\n

      \"\"<\/figure>\n\n\n\n

      Source: Thomas, Callum. Earnings: USA vs Rest of World. January 8, 2025. Topdown Charts.<\/p>\n\n\n\n

      As you can see, starting around 2012, U.S. earnings began diverging from their international counterparts, and while regulatory and fiscal policy in the U.S. might have contributed to this differential, the concentration of stellar performers further skewed the numbers. Maybe these two things are related, maybe not, but at the end of the day, one thing is clear: U.S. growth left international investors in the dust.<\/p>\n\n\n\n

      US 2 \u2013 International 0<\/strong><\/p>\n\n\n\n

      Should we then bet on the horse of U.S. growth dominance? No clear answer here, but at least historically, periods of abnormal growth have been followed by more moderate (or negative) periods of growth. After all, it\u2019s pretty hard for things to keep going up indefinitely!<\/p>\n\n\n\n

      Let\u2019s examine one last factor to this return differential.<\/p>\n\n\n\n

      Currency effects<\/strong><\/h2>\n\n\n\n

      Investing internationally is an implied bet against the U.S. dollar. When an investor buys an international asset, they must sell their U.S. dollars (forming an implied short position) and buy the local currency to purchase said security (establishing an implied long position).<\/p>\n\n\n\n

      So how has this bet paid off post-GFC? <\/p>\n\n\n\n

      Horribly! Once again, things did not pay off for international investors.<\/p>\n\n\n\n

      \"\"<\/figure>\n\n\n\n

      Source: YCharts. 01\/01\/2010 \u2013 12\/31\/2024. The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged and do not reflect management or trading fees, and one cannot invest directly in an index.<\/p>\n\n\n\n

      Looking at the dollar index, from January 2010 to December 2024, the USD realized a 39.33% return against a basket of other major currencies.\u00a0<\/p>\n\n\n\n

      US 3 \u2013 International 0<\/strong><\/p>\n\n\n\n

      Before deciding whether USD dominance is a trend or a fad, let\u2019s analyze the two events that stand out from this chart:<\/p>\n\n\n\n

        \n
      • 2014: The dollar strengthened as the Fed announced interest rate hikes following a strong economy while most other central banks lagged. <\/li>\n\n\n\n
      • 2022: A strong inflationary shock forced the Fed into a hiking cycle. This, along with perceived weakness in Europe threatened by the Russia-Ukraine war, fueled USD demand.<\/li>\n<\/ul>\n\n\n\n

        These two events alone account for most USD gains since 2010! And they both have one big common denominator: Interest rate policy. <\/p>\n\n\n\n

        While uncovered interest rate parity would dictate that lower yielding currencies should appreciate over time, and higher yielding currencies should depreciate over time, this has not been historically true. In fact, higher yielding currencies have tended to appreciate over time as investors reach for yield, while lower yielding currencies have tended to depreciate as investors flock to higher interest rate currencies. Hence, carry trades are possible! Therefore, changes in interest rate policy may be predictive of future currency moves. All else equal, higher yielding currencies tend to appreciate, and lower yielding currencies tend to depreciate.<\/p>\n\n\n\n

        Importantly, while the U.S. central bank adopted a significantly more hawkish stance in the mid 2010\u2019s, most other major central banks only began hiking until recently. This likely served as a strong tailwind to the dollar post-GFC. But should we expect this to repeat? Maybe, perhaps not. But let\u2019s at least examine what interest rates are doing today. <\/p>\n\n\n\n

        Most notably, the Bank of Japan finally reversed its negative interest rate policy just last year (!)<\/strong> and signaled a willingness to continue its rate-hiking cycle. And though the European Central Bank has continued pursuing an accommodative monetary stance, the incoming Trump administration has also been vocal in its desire to lower interest rates. The main difference being that the U.S. is starting from a higher level and has much more \u201croom\u201d to drop.<\/p>\n\n\n\n

        All this could serve as a potential mean-reversion trigger for the U.S. dollar that may take years to unwind.<\/p>\n\n\n\n

        As always, currencies can be tricky, and macro predictions are a fool\u2019s errand! Not to mention, trade balances, potential tariff wars, inflation and purchasing power differentials will most likely also influence future dollar moves (either up or down). Having said that, there are some legit reasons to believe that the dollar has headwinds ahead.<\/p>\n\n\n\n

        Conclusion<\/strong><\/p>\n\n\n\n

        Where do we go from here?<\/p>\n\n\n\n

        To make a soccer analogy, clearly, this return differential has not resembled the Argentina (3) \u2013 France (3) 2022 World Cup final. It\u2019s probably closer to the Brazil (1) \u2013 Germany (7) 2014 World Cup fiasco. The U.S. clearly<\/em> trounced most other countries for over a decade! <\/p>\n\n\n\n

        But the question is not \u201cwhat do I wish my portfolio would have looked like during that period?\u201d It\u2019s \u201cwhat is the best evidenced-based decision I can make for my portfolio going forward?\u201d<\/p>\n\n\n\n

        Investing 100% in the U.S. might make sense if:<\/p>\n\n\n\n

          \n
        1. You expect the U.S. to keep getting pricier than other markets, indefinitely.<\/li>\n\n\n\n
        2. You expect the U.S. to continue growing earnings at abnormally higher rates, indefinitely.<\/li>\n\n\n\n
        3. You expect the U.S. dollar to trounce other currencies, indefinitely.<\/li>\n<\/ol>\n\n\n\n

          If not, then international investing surely does look appealing, at least from a diversification perspective.<\/p>\n\n\n\n

          So what can investors do based on this information?<\/p>\n\n\n\n

          Here are three options:<\/p>\n\n\n\n

          1. Stay 100% U.S.<\/strong><\/p>\n\n\n\n

          If you believe U.S. stocks will keep crushing it, this is your move. But keep in mind: U.S. stocks are pricey and concentrated\u2014both of which are serious headwinds to overcome. Did I mention this is a pretty bold strategy?<\/p>\n\n\n\n

          2. Go 100% International<\/strong><\/p>\n\n\n\n

          Expecting U.S. valuations to mean-revert? This is your play. But remember, 10 years ago the U.S. was already the pricier option. Valuation-based timers missed out on a stellar decade. Ouch!<\/p>\n\n\n\n

          3. Diversify Globally<\/strong><\/p>\n\n\n\n

          Not sure which region will win over the next decade? Target both! Diversification is the only free lunch in investing, after all. Whether the U.S. keeps dominating or international markets stage a comeback, you\u2019ll be prepared for either scenario.<\/p>\n\n\n\n

          Spoiler alert, we believe #3 looks like the most sensible option. After all, prudent investing relies on following the evidence \u2013 and as presented, it surely looks like international diversification has its place in most portfolios.<\/p>\n\n\n\n

            \n
          1. \u201cIn 1990, US equity valuations (using Shiller CAPE) were about half that of EAFE; at the end of 2022, they were 1.5 times EAFE. Once you control for this tripling of relative valuations, the 4.6% return advantage falls to a statistically insignificant 1.2%.\u201d \u2013 International Diversification \u2013 Still Not Crazy After All These Years (2023), Asness, Ilmanen and Villalon.<\/li>\n<\/ol>\n","protected":false},"excerpt":{"rendered":"

            Multiple expansion seldom happens randomly. More often than not, fundamentals catalyze valuation revisions.<\/p>\n","protected":false},"author":1343,"featured_media":204898,"comment_status":"open","ping_status":"closed","sticky":true,"template":"","format":"standard","meta":{"_acf_changed":true,"footnotes":""},"categories":[339,338,341],"tags":[1006],"contributors-categories":[13651],"class_list":{"0":"post-218411","1":"post","2":"type-post","3":"status-publish","4":"format-standard","5":"has-post-thumbnail","7":"category-data-science","8":"category-ibkr-quant-news","9":"category-quant-development","10":"tag-fintech","11":"contributors-categories-alpha-architect"},"pp_statuses_selecting_workflow":false,"pp_workflow_action":"current","pp_status_selection":"publish","acf":[],"yoast_head":"\nIs It Time to Ditch International Stocks? | IBKR Quant<\/title>\n<meta name=\"description\" content=\"Multiple expansion seldom happens randomly. 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