FINANCIAL MARKET UPDATE 3.2.2021

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

THE CASE FOR INTERNATIONAL STOCKS

Decisions made by investors are often impacted by an array of behavioral biases. A very prevalent example of this would be the Home Bias, which can be described as the tendency to stick with what is familiar. This bias often manifests itself in investor portfolios as a dramatic emphasis on stocks from the country in which an investor lives. The net effect of this type of home bias is an allocation that is not sufficiently diversified and therefore carries additional and unnecessary risks.

Diversification is often referred to as the only “free lunch” in investing because it can improve risk adjusted-returns at little to no cost. Unfortunately, many investors don’t take full advantage of this benefit, particularly as it relates to investing in non-US companies. I pulled the chart below from a Vanguard study(1) from a few years ago. As you can see, US-based investors have typically allocated about 79% of their portfolios to US stocks, despite the US market only comprising about 51% of the global stock market at the time(2). The home bias is not just a US phenomenon. It is even more dramatic in other countries whose markets comprise much smaller portions of the global market.

Equity Home Bias by Country

Notes: Data as of December 31, 2014 (the latest available from the International Monetary Fund, or IMF) in U.S. dollars. Domestic investment is calculated by subtracting total foreign investment (as reported by the IMF) in a given country from its market capitalization in the MSCI All Country World Index. Given that the IMF data is voluntary, there may be some discrepancies between the market values in the survey and the MSCI ACWI. Sources: Vanguard, based on data from the IMF’s Coordinated Portfolio Investment Survey (2014), Barclays, Thomson Reuters Datastream, and FactSet.

In recent years, the US market has consistently outperformed international markets as a whole. Having a large home bias, therefore, has likely contributed to higher returns. Moving forward, we think there is a compelling case for investing outside of the US.

1. Higher Expected Returns

International stocks have not participated in the post-Financial Crisis (2008) bull market to the same degree that US stocks have. Investors concerned about the nosebleed valuations of domestic companies, particularly the large tech names that have driven the market higher in recent years, can find relatively attractive bargains abroad. As the chart below illustrates, the valuation of the international market relative to the domestic market is currently at an extreme level. This suggests international stocks are poised to outperform as that relationship normalizes. Lastly, the lower valuation generates a higher dividend yield for international companies. As of the end of January, the dividend yield on the S&P 500 was 1.6%, compared to the broad international market’s 2.7%(3).

Data from Morningstar Direct, as of 1/31/21. The relative measure compares an equally weighted composite of P/E, P/B, P/S, and P/CF for the MSCI EAFE Index relative to the Russell 3000, which is used as a proxy for the US market. Gaps in the green valuation line reflect missing source data.

2. Lower Portfolio Volatility

International stocks are not perfectly correlated with their US counterparts. As a result, combining them in a portfolio typically reduces volatility. The chart below, from Vanguard, illustrates this benefit. Based on their study, the maximum volatility reduction occurs when 20-50% of the equity portfolio is diversified into non-US stocks.

Volatility Reduction from incorporating International Equities

Notes: Non-U.S. equities represented by MSCI World Index ex USA and U.S. stocks are represented by the MSCI USA Index from March 31, 1970, through March 31, 2020. Past performance is no guarantee of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Sources: Derived from data provided by Vanguard and MSCI as of March 31, 2020.

It is very common for investors to exhibit some degree of home bias in their portfolios. While allocating heavily to US stocks has not hurt returns in recent years, our base expectation is that international stocks are priced to have higher returns moving forward. Additionally, international stocks provide the added benefits of improved diversification and lower portfolio volatility. We think this provides a compelling case for investing in international stocks moving forward.

1. Scott, Brian J., James Balsamo, Kelly N. McShane, and Christos Tasopoulos, 2017. The Global Case for Strategic Asset Allocation and an Examination of Home Bias. Valley Forge, Pa.: The Vanguard Group.

2. The US market is currently closer to 58% of the global market based on the MSCI All Country World Index

3. The international market dividend yield is based on the MSCI All Country World Ex-US Index

WEEK IN REVIEW

  • The Institute for Supply Management (ISM) published their Manufacturing Index, which showed manufacturing activity beat economist estimates last month, hitting the highest level since early 2018. The manufacturing data, combined with other strong economic data recently is pushing estimates for Q1 GDP higher. The Atlanta Fed’s GDPNow model, updated yesterday, now shows an estimated 10% annualized GDP growth rate for the quarter.
  • 96% of S&P 500 companies have reported earnings for the 4th quarter. According to Factset, 79% beat analyst estimates for earnings, while 76% beat revenue estimates. The earnings growth rate for companies that have reported Q4 earnings, blended with the estimates for companies that have not yet reported, has increased to 3.9%. The estimated YoY growth rate as of year-end was -9.4%. Earnings growth will need to continue to outpace near-term expectations for stocks to justify their current prices. Analysts typically revise estimates lower during the course of a quarter. After the first two months of Q1 2021, analysts have actually increased their estimates by 5.0%. That is a positive sign for the stock market.
  • There is a heavy slate of economic data still to come this week. On Wednesday, look for an update on services activity. On Thursday, we will get jobless claims and factory orders. Headlining the week of data will be the jobs report on Friday. Additionally, there will also be a handful of Federal Reserve speeches throughout the week. The market is anticipating some potential policy adjustments from the Fed at their March meeting. These adjustments include a change to the maturity profile within the Fed’s bond buying program (previously dubbed Operation Twist), where the Fed would sell shorter data bonds in favor of longer data bonds. Additionally, the market is expecting a potential increase to the interest on excess reserves (IOER) rate and reverse repo rate. These adjustments would not represent a change to their monetary policy stance; rather, they would focus on maintaining smooth market function.

HOT READS

Markets

  • Is Inflation a Risk? Not Now, But Some See Danger Ahead (WSJ)
  • Fed Policy Changes Could Be Coming In Response to Bond Market Turmoil, Economists Say (CNBC)
  • U.S. Factory Activity Scales Three-Year High, Price Pressures Building (Reuters)

Investing

  • The Stock Market is Smarter than All of Us (Ben Carlson)
  • Investors Piled Into This Magical Money Machine. Now They’re Stuck (Jason Zweig)
  • Berkshire Hathaway Letter to Shareholders (Warren Buffett)

Other

  • How Covid-19 Caused a Global Shortage of Semiconductors and Computer Chips (CNBC)
  • Aging Gracefully in the NBA Has Never Been Harder (Sports Illustrated)
  • The Best podcasts For Kids (Wired)

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

ECONOMIC CALENDAR

Source: MarketWatch

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ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

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JOSH JENKINS, CFA + CHIEF INVESTMENT OFFICER

Josh Jenkins is the Chief Investment Officer at Lutz Financial. With 10+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. In addition, he is responsible for portfolio trading, investment research and thought leadership for the division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst®
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

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