U.S. stocks fell about 5.26 percent in 2018. It was their first losing year in almost a decade. But now, it looks like U.S. stocks are back. From January 1 to June 4th, 2019, they gained about 13 percent.
By comparison, international stocks are increasingly looking like a hapless baseball team of has-beens that can’t seem to score a run. Long gone, are their heady days of 2001 to 2008, when they gained 94.41 percent. The struggling U.S. market gained about 34.31 percent over that same time period.
When International Stocks Last Basked in Glory
January 2001- January 2008
Since then, however, U.S. stocks have soared, gaining a whopping 144 percent from January 1, 2008 to June 4, 2019. By comparison, international stocks gained a paltry 12.04 percent over the same time period.
International Stocks Are Now Getting Left Behind
January 2008-June 4, 2019
To some, international stocks are like loaves of moldy bread. They might have been tasty once, but they certainly aren’t today. As a result, many people peg their biggest hopes on U.S. shares. Such thinking, however, could cost them plenty. Based on economic history, U.S. stocks are set to lag, while international stocks should score.
Here’s an explanation: Long-term, developed market profits track corporate earnings plus dividends. For example, if corporate earnings (for the stocks within an index) gain 200 percent over a fifteen-year period, the stock market’s profits should reflect that growth and make a similar gain.
Benjaman Graham, who was Warren Buffett’s professor at Columbia University, said the stock market’s direction is a short-term popularity contest. But it’s a long-term weighing machine. In other words, over a short time duration (this could be ten years) stock prices might not reflect corporate earnings growth. They could simply reflect investor’s confidence instead. But over long time periods, corporate earning’s growth and stock market growth are joined at the hip.
Between January 1, 2008 and June 5, 2019, U.S. stocks gained about 144 percent, including reinvested dividends. U.S. corporate profits made decent gains. But they didn’t gain anything close to 144 percent. That’s somewhat worrying.
In contrast, international stocks, including dividends, gained about 12.04 percent over the same time period. But their corporate profits ran circles around their stock market growth. This means, at some point, these stocks are set to move.
This isn’t based on forecasts or a working crystal ball. It’s based on something created by the economist, Robert J. Shiller. The 2013 Nobel Prize laureate devised something called a CAPE ratio (cyclically-adjusted price-to-earnings ratio). It measures inflation-adjusted corporate earnings over a ten-year period and compares them to stock market prices.
This isn’t a simple price-to-earnings (PE) ratio, which measures a single year’s earnings. Traditional PE ratios can make a stock (or a market) look artificially expensive or cheap because it calculates just a single year of corporate profits. Instead, the CAPE ratio averages inflation-adjusted earnings over a ten-year period. As a result, it’s far more accurate.
The following chart shows CAPE ratios for U.S. stocks during different time periods. On June 4, 2019, it was 28.87 times earnings. That’s expensive. In fact, it has only been this high twice before: in 1929, just before the market crash, and from 1997-2000. Both times, the decade ahead saw weak stock returns. And that’s Shiller’s point. He says that when the stock market’s CAPE ratio records a level that’s significantly higher than the median, a weak decade usually lies ahead. When it records a level that’s much lower than the median, a strong decade usually follows.
On June 4, 2019, the U.S. stock market’s CAPE ratio was 28.87 times earnings. That’s much higher than the median, 15.72 times earnings.
Just How Expensive Are U.S. Stocks?
Shiller’s CAPE Ratio
This doesn’t mean U.S. stocks won’t perform well in 2019 or 2020. They might soar to new heights, much as they did from 1997-2000. But history says the next ten years will likely look bleak.
Larry Swedroe and Kevin Grogan’s book, Reducing The Risk of Black Swans, provides a range of expectations. They referenced CAPE ratio data from AQR Capital Management’s Cliff Asness. Historically, when CAPE ratios exceeded 25 times earnings, the stock market barely beat inflation over the next ten years.
The blue bars below represent the average ten-year stock market returns following specific CAPE levels. The red bars show the best historical ten-year returns, following respective CAPE levels. And the green bars show the historical worst case scenarios for ten-year returns, based on different CAPE levels.
When the stock market’s CAPE ratio was between 21.1 and 25.1, stocks beat inflation over the following ten years by an average annual compound return of just 0.9 percent.
Ranges of Compound Annual Stock Market Gains After Inflation
Based on Different CAPE Levels
When CAPE ratios were between 15.7 and 17, stocks beat inflation by an average annual compound return of 5.6 percent.
And when CAPE ratios were below 9.6, stocks rocked. They beat inflation by a whopping 10.3 percent per year.
This brings us back to international stocks. In sharp contrast to U.S. shares, they aren’t priced in the nosebleed section. According to Star Capital, developed market European stocks traded at a CAPE level of 19.2 times earnings on April 30, 2019. The Emerging Markets traded at a CAPE ratio of just 16.1 times earnings. These aren’t exactly bargain basement levels. But compared to U.S. stocks, they’re a fireside sale.
This doesn’t mean, however, that you should dump U.S. shares. Nobody can see the future, so it’s better to own a globally diversified portfolio of low-cost index funds. Whatever you do, don’t shun international shares. The next decade bodes better for stocks beyond our border.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacherand Millionaire Expat: How To Build Wealth Living Overseas