Twenty years ago Hollywood gave us one of its most famous movie lines. Tom Cruise was playing sports agent, Jerry Maguire. Cuba Gooding Jr. played NFL football player, Rod Tidwell. He was a strong player who had posted good results. But he was frustrated. He wasn’t earning as much money as he thought he deserved. He wanted his agent, Jerry Maguire, to fix that. In the movie, Tidwell starts to dance around shirtless in his kitchen. Maguire is on the phone and Tidwell yells, “Show me the money!”
If your portfolio contains international stocks, you can relate to Tidwell’s cry. In the five years ending December 11, 2016, Vanguard’s Total Stock Market Index (VTSMX) of U.S. stocks gained 99.03 percent. By comparison, Vanguard’s International Stock Market Index (VGTSX) gained just 28.63 percent. It looks like a quarterback who keeps getting sacked.
But prices, relative to earnings, are never ignored forever. It’s much like football. Imagine two mid-career players. One averages about 15 touchdowns a season. Every year, he earns a million dollars. Another player averages about 16 touchdowns a year. But he earns $1 million one year, $1.5 million the next and $2 million in the following season.
At some point, that first player is going to get a raise. His salary is relatively low compared to the scores he can produce. Jerry Macguire’s Rod Tidwell was a lot like that, until his team gave him a raise.
It’s much the same with stocks. That’s why Warren Buffett’s mentor, Benjamin Graham, said the stock market was a short-term popularity contest, but a long term weighing machine. When a stock or a sector posts strong business numbers, it might take a while (even years) for the market to react. But it always does. It’s like a football player who just keeps getting better. Eventually, his salary will reflect what he’s doing on the field.
Cyclically adjusted price to earnings ratios, or CAPE ratios, show us which country’s stock markets are punching above their weight. It smooths out earnings over a period of time, instead of measuring productivity over a single year, much as a PE ratio would do.
Consider a football player midway through his career. He scores 10 touchdowns in one season, 12 in the next, 11 in the following season and 20 touchdowns in the next. If his worth were measured like a typical PE ratio he would be considered a player who scores 20 touchdowns a year. His worth would be based on that one great season. But would he deserve it, if it were just a lucky year?
If we smooth those performances out (as the CAPE level would smooth out earnings) we might expect 13 touchdowns a season. Yale University professor, Robert Shiller, compares stock prices with ten years of real (after inflation) earnings. It’s a tougher yardstick than a typical PE ratio because its level isn’t dramatically affected by an unusual level of earnings in a single calendar year.
Shiller found that when an overall stock market is priced well above its historical average CAPE level, it doesn’t usually perform as well in the decade ahead. But if it trades below its average CAPE level, like Jerry Maguire’s Rod Tidwell, prosperity lies ahead.
The average historical CAPE level for U.S. stocks is about 16 times earnings. According to researchers at Star Capital its CAPE level for the quarter ending September 31st was 25.5 times earnings. That’s expensive. Based on Shiller’s tests, U.S. stocks are now like wide receivers who face big defenders who can run like Usain Bolt. They could still run touchdowns. But it’s not going to be easy.
The historical average CAPE level of developed world international stocks is about 20 times earnings. It was about 15 times earnings on September 31st. That means developed world international stocks are like professional wide receivers against a bunch of college players. They could still have a tough time scoring. But the odds are with them winning.
Vanguard’s Emerging Markets Index (VEIEX) gained 13.63 percent for the year (to December 10th) compared to a 12.7 percent gain for Vanguard’s S&P 500 (VFINX). But emerging market stocks aren’t expensive. Their historical CAPE level is about 15 times earnings. Star Capital says they were trading at 14.4 on September 31st. By December, they were priced a bit cheaper. Their year-end CAPE level might end up lower than 14 times earnings.
Many investors, however, are turning up their noses. U.S. stocks have trounced international stocks over the past five, ten and fifteen year periods.
U.S. Stocks versus International Stocks
Compound Average Annual Returns - Ending December 9, 2016
|Average Annual Performance||3 Year||5 Year||10 Year|
|Source: Morningstar, using data from Vanguard’s U.S. Total Stock Market Index (VTSMX) and Vanguard’s International Stock Market Index (VGTSX)|
When investors see poor results many expect them to continue. Investors start to filter news. They use confirmation bias. That means they ignore what’s good and they focus on the bad. The media does that too because it draws a lot more viewers. But CAPE levels predict stock market returns much better than the media.
That doesn’t mean you should stuff your portfolio with international stocks. It could still take years for them to win. Nobody knows the future. It’s better, instead, to maintain a diversified portfolio. Make sure international stocks make up no more than half of your stock market allocation. If you’re patient and rebalance once a year, your portfolio should eventually show you the money.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacher and The Global Expatriate's Guide to Investing: From Millionaire Teacher to Millionaire Expat.