Tough times for international stocks

8/4/2008


The stock market has offered investors few places to hide in 2008. Many major U.S. indexes have posted double-digit declines this year, and the pain has extended overseas.

For the first time in five years, international stocks as a group are seeing an extended downturn, with the declines in several overseas markets greater than those of U.S. markets. The MSCI Europe, Australasia, Far East (EAFE) Index, the most prominent benchmark for developed foreign countries, is down nearly 17% year to date, a steeper decline than those of the most important U.S. indexes. The weakness in international stocks has extended to virtually every corner of the globe.

For example, the Dow Jones Americas Index is down 12% year to date; the Dow Jones Stoxx 600 Index of European stocks is down more than 23%; and the Dow Jones Asia-Pacific Index is down 15%. The declines are especially acute in China (country index down 43%), India (down 32%), and Russia (down 24%).

Weakness overseas is bad news for U.S. investors who have shoveled billions into international investments in recent years. As the chart below indicates, U.S. investors have roughly doubled their annual investment in foreign securities since 2003. And this increase in foreign investment has come at the expense of U.S. securities. According to the Investment Company Institute, domestic stock funds had a net outflow of $46 billion in 2007, versus a net inflow of $139 billion into foreign stock funds. Over the three-year period 2005 to 2007, domestic stock funds had total net outflows of $5 billion versus net new cash of $392 billion in international stock funds.

Performance was the catalyst for the overseas investor spending spree. From the end of 2004 to the end of 2007, the total cumulative return for U.S. markets was about 30%. That pales in comparison to the 74% return for world stock indexes (excluding the U.S.) and nearly 150% for emerging markets.

After such robust performances in recent years, this year’s declines beg the question: As performance suffers overseas, should investors maintain a bullish outlook on foreign investments? To answer this question, consider the major engines that drive stock prices both here and abroad — corporate profits, inflation, and interest rates. When you look at these three major drivers, you see some continuing headwinds for foreign stocks:

While growth rates overseas should continue to outpace that of the U.S., there are reasons for concern. Europe continues to be a trouble spot, and a softening economy is likely to crimp the profits of many companies in the European Union. Such commodity-dependent countries as Russia may see economic growth, and therefore corporate profits, suffer should commodity prices continue to decline.

Inflation, driven by fast-growing economies and high energy and food costs, has escalated in some foreign markets. In China, for example, inflation reached a 12-year high of 8.7% in February and remains in the 7% to 8% range. In India, wholesale price inflation has tripled this year to nearly 12%, around a 13-year high.

Rising inflation rates are driving a number of countries to boost interest rates. For example, India’s central bank has raised the rate at which it lends funds to commercial banks to its highest level in seven years. Sharply higher interest rates generally hurt stocks, making it more expensive to fund operations and expansion, and increasing the attractiveness of alternatives to equities, such as cash and fixed-income investments.

A big wild card for foreign investments is the dollar. While trying to peg the value of the dollar 12 months from now is probably a fool’s errand, it seems unlikely that the dollar will continue to decline at the rate seen over the last two years. And it would not be a surprise to see some stabilization in the dollar, especially if oil prices continue to fall. The weak dollar has benefited foreign stocks, and a strengthening U.S. currency could mute returns in the year ahead.

Finally, the social and political risks inherent in overseas investing could exacerbate over the next year. A number of countries are in the midst of leadership changes. Such regime shifts often lead to social and political instability, risks that make foreign markets less appealing to U.S. investors

Themes on Wall Street tend to move in broad cycles. International investing became increasingly popular during the five-year period when foreign stocks outperformed U.S. stocks. It is possible that 2008 could become a pivot point from which U.S. stocks embark on a multiyear period of outperformance versus international stocks. The Forecasts is not ready to proclaim that U.S. stocks will take the lead, but we are uncomfortable with the increasingly common wisdom that investors should hold at least 35% of their equity portfolios in foreign stocks. Foreign equity exposure still makes sense, with a 15% to 25% weighting suitable for most investors. Below are just two reasons for looking overseas.

  • By including foreign stocks in your fishing pond, you enlarge your opportunity set, gaining access to more potential winners.
  • International stocks enhance portfolio diversification. True, the correlation between U.S. stocks and those of other developed countries has increased in recent years. Yet returns are not perfectly correlated, and investors can diversify their portfolios through exposure to foreign stocks, particularly those from emerging markets.

The only foreign stock on the Forecasts recommended lists is AstraZeneca ($47; NYSE: AZN), a pharmaceutical giant based in the United Kingdom. The company has a number of strong-selling drugs, including Crestor for managing cholesterol, Nexium for acid-related stomach ailments, Seroquel for schizophrenia, and asthma treatment Symbicort. Earnings have topped Wall Street estimates in each of the last four quarters. While operational issues have plagued many of the largest drug stocks over the last several years, the industry has historically had defensive characteristics. AstraZeneca should hold up better than most in the current volatile market environment and represents a bright spot in the otherwise uninspiring drug group. The issue, rated Long-Term Buy, should deliver solid two- to four-year returns.

For investors who prefer to tap into foreign markets via mutual funds, the Vanguard International Value ($37; VTRIX) and Vanguard Emerging Markets Stock Index ($28; VEIEX) funds look attractive. Among international exchange-traded funds, the iShares MSCI EAFE Value ($59; EFV), iShares MSCI Emerging Markets ($44; EEM), and SPDR S&P International Small Cap ($29; GWX) have appeal.

FOREIGN FUND OPTIONS
—— Total Return ——
Fund (Price; Ticker)
YTD
(%)
3-Yr.
(Ann.)
(%)
Exp.
Ratio
(%)
Minimum
Investment
($)
iShares MSCI EAFE Value
($59; EFV)
(15.9)
NA
0.40
None
iShares MSCI Emerging Markets
($44; EEM)
(10.8)
21.8
0.74
None
SPDR S&P International Small Cap
($29; GWX)
(14.6)
NA
0.59
None
Vanguard Emerging Mkts. Stock
($28; VEIEX)
(16.0)
21.1
0.37
3,000
Vanguard International Value
($37; VTRIX)
(12.7)
12.3
0.40
3,000

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