International Stocks Appear Cheap Relative to U.S Stocks – 3 Reasons Investors Should Invest Cautiously Overseas

When assessing investment opportunities, one crucial consideration is the relative valuation of domestic and international equities. A commonly employed metric, the price-to-earnings ratio, serves as a barometer for gauging the relative expensiveness or cheapness of stocks.

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An analysis of the Vanguard Total Stock Market ETF Vanguard Total Stock Market ETF, a proxy for the total U.S. stock market, reveals a lofty P/E ratio of 25.66, substantially higher than its 10-year average of 18.47. Conversely, the MSCI EAFE ETF iShares MSCI EAFE ETF, representing international developed markets, exhibits a more modest P/E ratio of 17.14.

At first glance, this disparity in valuations might suggest that international stocks present a compelling value proposition for investors seeking better growth opportunities. However, a deeper examination of historical trends and underlying economic factors reveals a more nuanced picture.

While the current P/E ratio for U.S. stocks appears elevated relative to its historical average, international equities have consistently traded at a discount compared to their domestic counterparts. Over the past decade, the average P/E ratio for international stocks stands at 14.33, markedly lower than the U.S. average of 18.47. This persistent valuation gap can be attributed to several structural factors that have shaped the divergence between the two markets.

The Evolving U.S. Economic Landscape

The U.S. economy has undergone a transformative shift over the past decade, transitioning from a manufacturing and energy-driven economy to one dominated by the technology sector. This secular change has propelled the growth of innovative, disruptive companies that command premium valuations in the market. As the global leader in technological advancements, the U.S. is home to the world's largest and fastest-growing technology firms, which have significantly contributed to the elevated valuations observed in domestic equities.

In contrast, international market indices often comprise a more diverse array of companies, many of which operate in traditional, slower-growing sectors. This composition inherently translates into lower average growth rates and, consequently, more modest valuations compared to the U.S. market.

Another factor influencing the valuation differential is the relative strength of the U.S. dollar against other major currencies. Over the past decade, the dollar has appreciated, rendering the earnings of international companies less valuable when converted into U.S. dollars. This currency dynamic has further exacerbated the pricing gap between domestic and international equities from the perspective of U.S. investors.

Monetary Policy Divergence

The U.S. Federal Reserve's proactive approach to managing economic cycles and mitigating systemic risks has fostered a perception of stability and resilience in domestic markets. Since the Global Financial Crisis, the Fed has expanded its toolkit and demonstrated a willingness to intervene aggressively to insulate the economy and financial markets from significant shocks.

In contrast, international central banks have not always exhibited the same level of responsiveness or policy coordination, contributing to a heightened sense of risk associated with international markets. This perceived risk premium has manifested in the form of lower valuations for international equities relative to their U.S. counterparts.

The Case for International Diversification

While the structural factors outlined above suggest that the U.S. stock market may continue to command a valuation premium, an allocation to international equities can still offer valuable benefits to investors.

International markets are influenced by economic cycles and dynamics that operate independently from the U.S. economy. By incorporating international stocks into a portfolio, investors can achieve greater diversification and potentially reduce overall portfolio risk. This diversification can help smooth returns and reduce volatility, as international equities may respond differently to global economic events than domestic stocks.

While the U.S. market has been a leader in technological innovation, emerging markets and developing economies may present compelling growth prospects in various sectors. By investing in international equities, investors can gain exposure to these potential growth opportunities, which may not be fully represented in domestic indices.

Navigating the Value Vs. Growth Dilemma

While international stocks may appear attractively valued relative to their U.S. counterparts, relying solely on valuation metrics as a basis for investment decisions can be misleading. The structural factors underpinning the persistent valuation gap between domestic and international equities suggest that the U.S. market's premium may be justified by its leadership in innovation, growth, and economic resilience.

Investors seeking to capitalize on potential value opportunities in international markets should exercise caution and adopt a holistic approach that considers not only valuation metrics but also factors such as economic fundamentals, geopolitical risks, and currency dynamics. Additionally, maintaining a well-diversified portfolio that includes both domestic and international equities can help mitigate risks and potentially enhance overall returns.

The debate surrounding the relative attractiveness of value versus growth in international markets is a complex one, with no simple answers. While valuation metrics may suggest that international stocks offer better value, the structural factors underpinning the persistent valuation gap between domestic and international equities should not be overlooked.

Ultimately, investors must carefully evaluate their investment objectives, risk tolerance, and time horizons to determine the appropriate allocation between domestic and international equities. A well-diversified portfolio that balances exposure to both markets may be the most prudent approach, allowing investors to benefit from the strengths of each while mitigating potential risks.

By Dan Irvine, Contributor