October 4, 2018


Dear Investor,


The only stocks going up this year are U.S. stocks—on the back of Trump’s corporate tax cuts, which have increased earnings at domestic companies. But the effect of this tax break is already well baked into stock prices and U.S. stocks are now dangerously overvalued, trading at 18 times forward earnings and 25 times trailing earnings.

Meanwhile, our higher weighting of international stocks, which dramatically helped us last year, is hurting us this year. Nearly all major stock indices outside the U.S. (except Japan) are down or underperforming domestic stocks year-to-date. As a result, our performance has lagged the indices over the past two quarters.

In over 20 years of managing money, I’ve seen this type of disparity countless times before. As I was last year, many times I’ve been on the right side of the trend; occasionally the wrong. The only certainty is that any trend will reverse eventually. I can’t say whether that will be in a week, six months, or a year, but at some point, the fashionable sector (i.e. U.S. stocks) becomes deeply unfashionable and the out-of-favor sector (i.e. international) once again finds itself intensely appreciated. As surely as wide neckties and narrow ones trade places in the fashion hierarchy, so do major asset classes.

But I am not depending on a simple reversion to the mean. The reality is that international stocks, whether they be emerging markets such as China, Eastern Europe or Latin America (or a developed overseas market such as Japan’s) are compellingly undervalued, while U.S. stocks are precariously overvalued. In fact, international stocks are undervalued to roughly the same extent that U.S. stocks are overvalued. The question often arises: why not buy more U.S. stocks if the U.S. is going up? The reason is that what is overvalued has a lower expected future return, while what is undervalued has a higher one.

Consider the two major measures of valuation that show this great disparity: dividend yield and price-to-earnings ratio (p/e ratio). As stated above, U.S. stocks are trading at 18 times forward earnings. This means an investor in domestic stocks is paying 18 times for every dollar in earnings. A p/e ratio is an assessment of the value of stocks the same way a price-to-square-foot ratio is an assessment of the value in real estate. The long-term average p/e ratio is approximately 15 for U.S. stocks; based on this measure, they’re roughly 20% overvalued. Meanwhile, emerging market stocks are trading at roughly 11 times forward earnings, while their historical average is typically higher than even that of U.S. stocks, around 16 times (emerging market stocks typically trade at a higher multiple because they have a higher growth rate). This implies that emerging markets stocks are perhaps 30% undervalued. This means that to buy U.S. stocks now and eschew emerging markets stocks is like overpaying for an apartment whose fair value is $1,500/square foot by ponying up $1,800/ft while ignoring that better one that usually goes for $1,600/ft which is now selling at the fire sale price of $1,100/ft. It’s not rational, but that’s what people do when they see a trend: they continue to follow it. They buy what goes up because it already went up instead of seeing where the current value resides. For a while this works. But as every bust from the dotcoms to Bitcoin has shown, it only works until it stops working.

If you’re not convinced by the p/e ratio difference, then you only have to look at dividend yields to see the crazy disparity there. U.S. stocks are paying an estimated forward dividend yield of 1.84%. Meanwhile, emerging markets are paying 3.35%, fully 82% higher. Due to their faster growth rates, emerging markets should have a lower dividend yield—but they currently have one nearly double that of domestic stocks. Not since the dotcoms traded at a ridiculous 90 times earnings in 1999 and forsaken industrial stocks traded at a third of that have I seen such a gap. And we all know how that story ended.

Many will say there are good reasons to avoid international stocks: tariffs, trade wars and rising interest rates. But that ignores that U.S. stocks will eventually reflect all the same factors. More importantly, it ignores the fact that emerging market stock valuations already assume the worst. As they say in investing: it’s already priced in.

This is not to say that if U.S. stocks go down, international ones will go up on any given day. Short-term declines can swamp all boats temporarily, and the knee-jerk reaction of traders on bad news days is to sell all stocks. But it does mean that eventually international stocks should recover much faster than U.S. stocks and, more importantly, should eventually have a much higher expected return—again, not necessarily over the coming week or year. But over the coming 3 to 5 years, I would be very surprised if international stock returns did not exceed those here at home by a wide measure.

Bottom line: based on current p/e ratios and dividend yields, I would estimate domestic stocks returns to range from approximately 5%–8% annually over the next 3 to 5 years, vs. approximately 7%–16% for the emerging markets.

There are never any guarantees in the world of investing so I cannot give any assurances. But all odds and valuation measures point to international stocks being the place to be going forward.

With best wishes for the coming quarter.