- The sharp divergence between U.S. and non-U.S. equities is one of the most interesting anomalies in world markets today.
- Non-U.S. markets are multi-decade cheap versus the S&P 500, but have not demonstrated the leadership normally associated with long-term reversals.
- It’s okay to be late to the party. Favor the U.S. for now.
Every now and then I review the technical status of non-U.S. equities, a sector comprising 50% of global capitalization. For this exercise, I use Vanguard’s All-World ex-U.S. fund (VEU) and its components, Vanguard Europe (VGK), Vanguard Pacific (VPL), and Vanguard Emerging Markets (VWO).
In recent years, the divergence between U.S. and non-U.S. equities has been one of the most interesting anomalies in world markets. Since 2009, the rest of the world has lost roughly half its value relative to the S&P 500 (Chart 1). This is true of all major segments (Charts 2-4).
Chart 1. Relative strength of non-U.S. equities versus S&P 500
Chart 2. Relative strength of Developed Europe versus S&P 500
Chart 3. Relative strength of Developed Pacific versus S&P 500
Chart 4. Relative strength of Emerging Markets versus S&P 500
Will non-U.S. markets ever bounce back? Yes, most likely. Looking back three decades, using the Hang Seng Index as proxy, we note that wide swings in relative strength are the rule rather than the exception (Chart 5). The swings are presumably caused by variations in business-cycle dynamics. “Animal spirits” are also at play, as relative strength appears to overshoot in both directions.
Chart 5. Relative strength of Hang Seng Index versus S&P 500
Note: Hong Kong dollar pegged to the U.S. dollar for entire chart period.
The same conclusion can be reached via fundamental valuation. Non-U.S. equities are multi-decade cheap versus the S&P 500 (Chart 6). It’s likely then, that the next long-term trend will favor non-U.S. markets. Some advisors are betting that a new upswing is already underway. But many have called premature bottoms over the past few years.
Chart 6. Relative valuation of non-U.S. equities versus S&P 500
We, therefore, maintain a cautious outlook. Diversification is always welcome, so it’s okay to establish or maintain a toehold in non-U.S. markets. But we’d prefer to see further evidence of trend reversal before establishing a larger position.
This view is justified if you believe that the eventual uptrend will be long-term in nature. The average duration of the relative-strength cycles in Chart 5 is seven years, and the minimum halfway mark – in terms of amplitude – is roughly three years. It’s okay to be late to the party if history is any guide.
So what evidence would improve the odds of a long-term reversal?
We’d like to see definitive leadership from non-U.S. markets. Global equities logged an important cyclical bottom in January 2016. Sixteen months later, only the Emerging Market segment has outperformed the S&P 500 – but only to a modest degree. This is not leadership, as noted in Charts 1-4.
Market technicians have long recognized the importance of early leadership in relation to cyclical bottoms. Sectors demonstrating early strength are best candidates for continued outperformance. In many cases, leading sectors turn upward in relative strength ahead of price bottoms.
Returning to the Hang Seng Index, we note early strength relative to the October 1990, October 1998, October 2002, and March 2009 bottoms (Chart 7). We also note the negative implications of early weakness relative to the November 1994 and October 2011 bottoms.
Chart 7. Relative Strength of Hang Seng Index noting important bottoms in the S&P 500
No indicator is perfect. But the presence or absence of leadership is worth noting. We have yet to observe it in Developed Europe or Developed Pacific. As noted in Chart 4, however, Emerging Markets might – repeat might – be demonstrating some sort of leadership. Zooming in, we note that VWO has generated a modicum of relative strength in relation to the January 2016 bottom (Chart 8).
Chart 8. Emerging Markets close-up
A hint of strength, however, is not true leadership. Two observations warrant caution. First, there was no upturn in relative strength ahead of the bottom. Second, relative strength nearly collapsed after the U.S. election. We would argue, therefore, that it’s too early to declare a long-term reversal. At a minimum, we’d like to see relative strength surpass its pre-election threshold. This would constitute a higher-high following a higher-low, adding confidence to the case for trend reversal.
Non-U.S. markets have not demonstrated the type of leadership normally associated with long-term reversals. The relative-strength lines for Developed Europe and Developed Pacific remain below their January 2016 levels. The Emerging Market segment has shown a modicum of strength but remains unconvincing.
We’d like to see higher-lows and higher-highs in relative strength (above January 2016 levels) before concluding that any non-U.S. segment has begun a long-term upswing in relative performance. Markets must stop declining before they can advance. We think there will be plenty of time to participate after healthier readings are observed.
It’s okay to be late to the party. Favor U.S. equities for now.