Foreign Equities Aren't as Cheap as You Might Think

Foreign equities haven't kept pace with their U.S. counterparts, in dollar terms, for quite some time. The S&P 500 has beaten the MSCI All-Country World ex USA Index (ACWI) in five of the last seven calendar years. Since equity markets hit bottom during the credit crisis in March 2009, the S&P 500 has gained an annualized 22.5% through January versus 14.9% for the ACWI. The gap has been especially pronounced during the past three years, with the S&P 500 gaining 17.5% annualized versus just 6.6% for the ACWI.

There's no shortage of reasons as to why foreign equities have lagged. U.S. companies have enjoyed far better earnings growth and higher returns on capital since the last recession. The U.S. economy has also been stronger than most developed markets, with Europe's economy stuck in neutral; emerging-markets growth is slowing, too. Plus, there's headline risk coming out of a Greece again. With the country quickly running out of money and a new government looking to end austerity measures, the Greek equity market has been in free-fall. In the nearly 12 months since its 52-week high in March 2014, the MSCI Greece Index is down more than 60%. This has little direct impact on the ACWI's returns given that Greece is just 0.1% of the index, but the country adds uncertainty to the eurozone overall.

Usually when there's such a wide chasm in returns between two asset classes, it opens an equally large gap in valuations. That is part of what normally makes rebalancing so effective. When two asset classes diverge inversely from their target weightings, the lagging asset is often cheaper than the one that has outperformed. Reversion to the mean then eventually leads the lagging asset to pull ahead.

Blame the Dollar However, that valuation gap doesn't exist to the usual extent in this case because so much of the recent U.S. equity outperformance has owed to the soaring dollar. During the 12 months through Feb. 11, 2015, the U.S. dollar has gained 17.3% versus the euro, 15% versus the yen, and 7.4% versus the pound.

In local-currency terms, foreign equities have actually done pretty well. Indeed, last week, Japan's Nikkei Average hit its highest level since July 2007. The U.K.'s FTSE 100 Index nearly hit a 15-year high in the first week of February. While the MSCI ACWI ex USA Index lost 0.7% in dollar terms over the past 12 months through Feb. 11, it rose a solid 12.3% when measured in local currencies. This still trails the S&P 500's 16.1% gain during that stretch but by a far smaller margin.

So while foreign equities are arguably cheaper than U.S. equities, they aren't exactly cheap, at least not relative to their own history. The ACWI's price/earnings ratio is currently 15.6, its highest level since October 2007. Comparing price multiples across markets can be problematic, but broadly speaking, that's fairly close to the S&P 500's 17.9. Compare that with the ACWI's 10.3 P/E ratio in May 2012 versus the S&P 500's 14.0, two months before European Central Bank president Mario Draghi pledged to do "whatever it takes" to preserve the euro.

Impact of Cheap Currencies

It's possible that cheaper currencies could lead to faster earnings growth for overseas companies, but the impact of currencies isn't always clear. For instance, although the products of foreign companies may now be cheaper in dollar terms, their inputs may be more expensive, too. The picture is further muddied for large-cap companies that hedge a portion of their currency exposure or have global operations. Take Japanese automakers such as

The dollar will likely weaken against other currencies at some point; currencies have tended to be mean-reverting over time, too. This would give foreign-equity funds with unhedged currency exposure a boost. However, many forecasters see this as unlikely in the short term given that the Federal Reserve plans to raise rates in 2015, while the ECB and the Bank of Japan have loosened monetary policy to fight deflation.

This isn't an argument against rebalancing or reallocating a part of one's portfolio into foreign equities. Foreign equities may very well outperform their U.S. counterparts in the years to come, whether because of currency gains, better share performance, or both. But be aware that the case for a foreign-equity revival isn't as compelling as in years past from a valuation standpoint.