What’s going on with the international stock market? Prudent investors use international stocks to diversify their portfolios. When domestic stocks are lagging, we expect the international markets to provide a buffer. But, has it worked out that way?

Albert Einstein suggested that insanity is doing the same thing over and over again and expecting different results. Right about now, investors that have money in international stocks are probably wondering if they are insane.

International Stock Index

For the purposes of this discussion, international stocks are represented by the MSCI EAFE index (Morgan Stanley Capital International) and domestic stocks by the S&P 500 index (Standard and Poor’s). The EAFE (acronym for Europe, Australasia, and Far East) has the longest track record of any broad international index and is comprised primarily of large-cap stocks from developed countries. The EAFE was incepted on December 31, 1969, so it has a 46-year track record. The returns listed in this article were calculated based on data from Wikipedia’s website.

Why question a continued investment in international stocks? Over the past six calendar years, international stocks have underperformed domestic stocks in five of those years and barely exceeded domestic stocks in the sixth year (2012: 17.3 percent vs. 16.0 percent).

In fact, the EAFE has underperformed the S&P 500 by a total of 63 percent over the last five years. This is a difference of 10 percent per year! (The compounding effect of 10 percent per year results in a total five year disparity of 63 percent.)

Time to Buy?

Does a prolonged period of underperformance suggest a turnaround is imminent? Statistically speaking, comparing two variables (indices) with a sample size of 46 common experiences (years) does not necessarily produce statistically significant results. In other words, take the following thoughts with a few grains of salt.

In reviewing trailing 10-year returns, I looked at how often the EAFE underperformed over ten years and what was the resulting 10-year return going forward.  From 1970-2015, for the comparable periods available, the EAFE underperformed the S&P 500, 14 out of 27 times. Of those 14 occasions, the EAFE outperformed the S&P 500 during the next ten-year period a total of nine times – almost a two to one ratio. 

Good news: Based on this data, the odds of international stocks outperforming domestic stocks over the next ten years are in our favor.

Time to Sell?

I also looked at the same data using five-year trailing and forward returns and 15-year trailing and forward returns. The five-year returns were inconclusive. The EAFE underperformed the S&P 500 15 times over five-year periods, but then went on to outperform in eight of those 15 times, which is about the same odds as correctly guessing a coin flip!

Staggeringly, when looking at 15-year returns, the EAFE underperformed nine times and continued to underperform the S&P 500 over the next 15 years in each of the nine instances. A 100 percent occurrence is rare and normally would suggest a strong correlation between past and future performance. However, all but one of the 15-year occurrences were impacted by the domestically dominated internet revolution. I would argue that we are unlikely to see a similar period of stock market performance in our lifetimes. 

So Now What?

Ten-year time periods suggest now is a good time to buy international stocks and 15-year time periods suggest you should only own domestic stocks.  What should investors do?

"Momentum investors" would sell the underperforming international stocks and purchase the investments that are outperforming, i.e. domestic stocks.  Caution: This takes appropriate timing. If you are late to the game and the momentum is waning, you may mistakenly buy high and sell low. 

"Portfolio rebalancing" is a discipline that suggests you sell investments that are doing well and purchase those that are lagging. For example, let’s assume your original target allocation for your stock portfolio is 20 percent international stocks and 80 percent domestic. Due to the performance of the markets, your portfolio is now 5 percent international and 95 percent domestic. If you rebalance your portfolio, you would take profits by selling the domestic stocks that have increased in value and then reinvest in the international stocks that have gone down in value, and are potentially undervalued, to bring your portfolio back to a 20 percent/80 percent balance. When implemented appropriately, managing your portfolio with the rebalancing discipline forces you to sell high and buy low.

Summary

Historical data can be helpful, but in this case the research does not provide a clear cut direction for investors. Whether you adhere to the "momentum investor" philosophy or the discipline of "portfolio rebalancing," inconclusive research is what makes investing an art as much as a science. Happy investing!

This article was contributed by Bill Wendling, CFA, an Investment Manager at Bedel Financial Consulting, Inc.

Elaine E. Bedel, CFP®, is CEO and president of Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. She is a featured guest each Wednesday on the WTHR (NBC, Indianapolis) Channel 13 News at Noon, "Your Money" segment. Elaine’s book, "Advice You Never Asked For… But wished you had," is available on Amazon.com. For more information, visit www.BedelFinancial.com or email Elaine at ebedel@bedelfinancial.com.

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