Foreign stocks have had a fine year, up more than 20 percent in developed countries and 27 percent in the emerging markets, and more U.S.-based investors have gone along for the ride. But now analysts warn there are factors that can derail the bull run. They note that price-to-earning ratios on foreign stocks are back near pre-financial crisis highs.
Five of the top 10 ETFs this year, as ranked by new investor money, track the MSCI EAFE developed markets index and the MSCI Emerging Markets Index. These overseas ETFs have taken in a combined $62 billion from investors through the end of September — that's double the haul for top S&P 500 ETFs, according to FactSet Research Systems. There are more U.S. bond ETFs (three) than S&P 500 portfolios (2) in the top 10 for new ETF money in 2017.
What's been driving the flood of money to overseas stock bets? First, even as flows to foreign stocks have outpaced the U.S., an S&P 500 ETF is still No. 1 in overall inflows this year. U.S. investors have a history of being under-invested overseas, with more need to catch up in these markets. Many financial advisors urge U.S. investors to put at least 20 percent of their holdings in overseas stocks. Some go much further. Dave Yeske, managing director of financial advisory firm Yeske Buie, said he has always been "geographically neutral," which has resulted in allocations that are roughly half U.S. and half overseas — and roughly 11 percent emerging markets, specifically, right now.
A central bank easing story that has refocused on foreign markets, as the Federal Reserve raises rates and sells off bond holdings, along with a nine-year bull market run for U.S. stocks — all at record highs now — has pushed more money to foreign stock markets.
"Investors have been pouring money into European and emerging markets ETFs as they were worried about stretched valuations of US stocks ... even though the second-longest bull market in history showed no signs of slowing down and market volatility remained muted," said Neena Mishra, director of ETF research at Zacks Investment Research.
Timothy J. Bain, financial advisor at Spark Asset Management in Statesville, North Carolina, is among the enthusiasts. He said emerging market stocks remain relatively cheap, trading at about half the Standard & Poor's 500 valuation, using the standard price-to-earnings ratio.
"Since closing above the October 2007 pre-crash high of around 1550 in March 2013, the S&P 500 has gone up over 60 percent, while the markets of Europe and Asia are still below their pre-crisis highs in 2007," said Cern Basher, president and chief investment officer at Brilliant Advice in Cincinnati.
But not below by much.
On a forward earnings basis, emerging markets still look a lot better than U.S. stocks: The MSCI Emerging Markets Index is trading at about 12 times expected earnings, compared to 23 times for the stocks in the Standard & Poor's 500. But overseas stocks are no longer quite as cheap as they once were — especially when compared to their own historical valuations rather than to the S&P 500. In fact, they are back near pre-financial crisis highs and, in the case of emerging markets, have risen above the long-term historical average.
The MSCI Emerging Markets Index is at a current trailing price-to-earnings ratio of roughly 16 times higher than its 20-year average of 14.5 times, according to Wells Fargo Investment Institute global quantitative strategist Sameer Samana. "It's rarely been higher except in recession, when earnings tend to decline significantly, pushing the denominator down," Samana said. "One theme we are struggling with is that almost nothing is cheap in the world, across the board, high asset prices."
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"Stocks in other parts of the world have also risen significantly," Mishra said. But she cited two reasons to remain invested in overseas developed markets: Strong economic growth and receding political risks (excepting Catalonia) in Europe, and a Japanese economy showing signs of a rebound, with stocks still below their now-distant 1989 peak.
Since the start of 2009, the S&P 500 index is up more than 232 percent, whereas the broader, Europe and EM indexes have gained about 110 percent, and Japanese stocks have risen about 71 percent. For some advisors, that performance disconnect is one more reason to increase overseas bets.
"The S&P did much better the last five years, but that only increases the need to reallocate in 2017" by building up foreign holdings, said John Creswell, executive managing director at Duff & Phelps Investment Management in Chicago.
Another valuation measure created by Yale economist Robert Shiller — CAPE — suggests that emerging market stocks remain the best value relative to most other stock markets.
Ranking of regions based on CAPE
German fund manager StarCapital, which manages roughly $2.3 billion and uses CAPE as part of its global stock analysis, noted in recent research that stock markets historically have been valued with an average CAPE of 18.3. Currently, only 15 out of 40 country stock markets it studies are below this historic mean — Russia and Brazil are among the best values based on the CAPE ratio. On a regional CAPE valuation basis, StarCapital's view is that emerging markets remain attractive, Europe is neutral, and North America is expensive.
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Louis Kokernak , an advisor with Haven Financial Advisors in Austin, Texas, is focused on a Federal Reserve that has begun to raise interest rates, which should trim U.S. stock gains, while central bankers in Europe and Japan are still stimulating markets with low-rate policies. However, the market does expect the ECB to soon follow in the Fed's footsteps and pull back on easing. The ECB has indicated it's a discussion that didn't occur during the summer but may begin in earnest this fall.
"The ECB is talking about tapering, and the Bank of England is talking about raising rates, so we've gone from across-the-board global central bankers' easing to now across-the-board thinking about pulling back on unconventional policy," Samana said. "The unusually low rates, even negative overseas rates, put upward pressure on valuations, whether stocks or high-yield or emerging markets debt."
A steadily declining dollar in 2017 also has been a boost to foreign stocks.
The MSCI EAFE, an index of stocks in 21 developed countries, not including the United States, is up about 20 percent in U.S. dollars since the start of the year, but just under 10 percent in local currencies, according to Morningstar. The MSCI Emerging Markets Index, including 24 countries, like Brazil, China and Russia, is up 27 percent in dollars, 23 percent in local currencies, according to Morningstar.
But what if the dollar were to rise instead of continuing to fall, as it has showed signs of doing since last month? That would support the case against buying foreign stocks now.
"If the Fed raises rates in December and the dollar continues its recent uptrend, we could see some investors pulling money out of emerging markets," Mishra said. But she added that most developing countries now have much better economic fundamentals, with sizable current account surpluses and strong foreign exchange reserves. "I don't think we would see a repeat of the Taper Tantrum," she said.
Creswell argues that exchange rates are too unpredictable to use as a key factor in investing. "Over time you will win some and lose some on currency," he said. "The goal is to buy great companies that make you money and have the currency even out over time."
The most compelling reason to stick with booming overseas stocks may be the most basic element of portfolio planning, at least for investors who have their target weights set right and are not nearing a major life event, such as retirement.
Yeske said his firm sticks with its target allocations over time and lets the markets tell it when a market is expensive or cheap through rebalancing. "We're making all of our adjustments at the margin, never making big bets," he said.
Creswell noted that developed and emerging markets account for roughly half of the world's stock market valuation. It's also been about a decade since developing markets eclipsed developed economies in percentage of global GDP contributed. Creswell and Yeske both said most U.S. investors should be putting more money into foreign stocks, with an added focus now on value stocks, which have "vastly underperformed" growth stocks.
Even while some of his firm's research shows asset prices expensive around the globe, Peter Donisanu, global research analyst for the Wells Fargo Investment Institute, said, "We believe that U.S. investors in general are broadly under-allocated to foreign assets."
— By Jeff Brown, special to CNBC.com