Over the past two weeks, the US-focused S&P 500 has been on a wild roller-coaster ride. After falling nearly 10% from the late summer peak, the index has recouped over two-thirds of the losses and reestablished a position in the middle of the 1925 to 2000 trading range that’s prevailed since early summer.
The MSCI EAFE, an index composed of stocks from Europe, Australia, and the developed Far East, presents a vastly different story. During the current correction, the EAFE declined approximately 15% peak to trough and has only recovered about 4% during the recent bounce. Similarly, the MSCI Emerging Markets index, which showed promise earlier in the year, fell over 12% peak to trough and has barely rallied back during the recent move higher in global equities off the lows.
The large performance gap between US equities and international equities, both developed and emerging market, has been an issue for five years running. From the end of 2009 through 10/23/14, the S&P 500 has nearly doubled, up 93%. In contrast, the MSCI EAFE is up 33.7% and the Emerging Market index is up a paltry 13.54% total. Wow, talk about turning conventional wisdom on its head! Few talking heads in 2009 would have predicted that the US would so handily beat emerging markets over the ensuing five years.
We’ve pointed out in the past how relative strength between the various indices tends to trend for long periods of time. Let’s take a quick look at the long-term relative strength charts for the S&P 500 vs. the EAFE and the S&P 500 vs. the MSCI Emerging Markets Index.
Since the formation of the EAFE Index in the early-1970s, under and outperformance trends appear to run in 20-year cycles. The EAFE, running on the back of a strong Japanese equity rally, significantly outperformed the S&P 500 from the early 1970s until the early 1990s. Since then, except for a brief period of outperformance in the mid-2000s, the S&P 500 has maintained the upper hand. With the recent relative underperformance of the EAFE, generally associated with the continued economic and market malaise in Europe, the EAFE/SPX relative strength index has now fallen to levels not observed since the early 1970s. The post-financial crisis years have not been kind at all to developed international equity markets.
As seen above, the over and underperformance cycles for emerging market equities have run at shorter time intervals (approximately 10 years). Emerging market equities had a strong run in the 1990s until crises in the back half of the decade, notably the Asian and Russian financial crises, seriously dented money flows into emerging markets. During the decade up to and through the global financial crisis, we see significant outperformance reflecting the general “emerging market miracle” economic outperformance observed during that period. Since then, the ratio has dropped like a stone and remains comfortably below the long-term moving average.
If there’s a silver lining to the relative strength story, past moves through the +1 or -1 standard deviation bands have been precursors to future trend changes. In this case, there may be some light at the end of the tunnel for EAFE stocks. If past experience is any guide, however, emerging market stocks may have to experience more relative performance pain before they regain their footing.
Adding long-term valuation to the analysis potentially adds another silver lining for international markets. Currently the EAFE and the Emerging Market indices are trading a solid discounts to the S&P 500 when using 10-year, cyclically adjusted P/E ratios. The S&P 500 is currently trading at 21.7x cyclically adjusted pro-forma earnings, nearly 1 standard deviation above the long-term median of 16.4x. Alternately, the EAFE is trading at approximately 15.9x, below the long-term median, and the Emerging Market index is trading at 12.3x, the lowest levels since the financial crisis. Moreover, the ratio of the S&P 500 P/E ratio to both the EAFE and Emerging Market P/E ratios is at the highest levels observed over the past decade. The valuation divergence has become as significant as the performance divergence.
CAPE PE ratios in isolation have been solid predictors of future 10-year performance regardless of the overall qualitative economic and investing environments across regions. Again, if valuation history is any guide, odds seem to favor a reversal in the relative performance trends in the coming years. The valuation ratio charts for the three indices are presented below.
