“Foreign stocks are in the red this year, even after a rally on Friday, while U.S. indexes set record after record. Japan is in recession, Europe is stagnating and the dollar is booming.”

Source: USA Today

After an opening line like this one from a recent article in the Wall Street Journal by Jason Zweig, it’s no surprise that, for the first time in months, investors pulled money out of international stock mutual funds in October. With freshly released higher GDP growth for Q3, the US is on a track to surpass nearly all expectations for this year, while Europe, China, Japan, and Brazil all continue to disappoint.

As our clients will know, the core of our investment philosophy is a belief that over the long run, valuations drive markets. Different areas of the market, at different times, experience bull market runs that take them from cheap (or relatively inexpensive) to fair value. In extreme situations, markets can even overrun and enter the “bubble” category.

Our strategy is simple: we want to own asset classes in areas of the market that are undervalued relative their long-term averages, and we want sell them when they hit valuations above their long-term averages. This discipline is a very important part of reducing exposure to overheated areas of the market, and has been a key driver of our returns over the last 15 years. Over the last 18 months it has led us to increase our international exposure in our equity portfolios significantly. However, since valuation unfortunately does not tell you anything about timing, so far that tactical move has not helped our clients portfolios.

“Still, there are plenty of reasons for U.S. investors to hold foreign stocks. The People’s Bank of China and European Central Bank President Mario Draghi both made potentially bullish moves this week for investors in those markets… More broadly, foreign stocks can be an effective hedge against a rise in U.S. interest rates.”

The article goes on to argue that, with the Fed potentially increasing interest rates early next year, foreign stocks may have some potential advantages. For one, a recent study has shown that during the last 60 years, when the Fed has increased interest rates, the stock market has gone nowhere for the following six months. However, international stocks have outperformed by an average of 4 percent in the same periods.

Second, the U.S. market is significantly more expensive than overseas markets. So, the slightest surprise to the positive side for those markets will probably provide a better reaction than it would for the U.S., which carries much higher expectations for growth.

 “’If you get one whiff of good economic news in Europe, earnings will go up and stock prices could surprise on the upside,’ says Mr. Stromberg of T. Rowe Price, ‘because expectations are so low.'”

We will continue to follow our discipline, which will continue to lead us to areas of the market that are currently out of favor. It is by recognizing and taking advantage of these opportunities that we hope to outperform in the long run.

(The quotations above are from “A Foreign Affair Can Benefit Stocks Investors” by Jason Zweig, published in the November 22, 2014 Wall Street Journal. Read the full article here.)