A definite feature of the last decade has been the persistent underperformance of European and Asian stocks vs US stocks. Foreign stocks have underperformed with such consistency that it’s almost expected at this point. Nonetheless, we may be at a tactical point where a mean “catch up” of the foreign laggards could be in the offing, supported by both technical and fundamental factors.
In the first chart we plot the relative performance of the Bloomberg EAFE index vs the S&P 500 (top panel) and the relative strength index of the ratio (bottom panel). What we are seeing currently is the relative performance of EAFE stocks trading way below the 200 day average and also having reached an oversold condition at the same time. In the past, this has been the setup for some kind of mean reversion.
A mean reversion of performance is also supported by fundamentals. Over the last year the forward return on equity of EAFE stocks has improved greatly relative to US stocks. Indeed, 12 months ago foreign stocks had a ROE 75% lower than US stocks. But, over the course of the last year, EAFE stocks have narrowed the gap considerably and now sport a ROE just 20% lower than US stocks.
At the same time the forward PE ratio of EAFE stocks has collapsed vs US stocks. One year ago EAFE stocks traded at a 20% discount to US stocks. Today they trade at a 32% discount.
We take note when a group of stocks falls out of favor at the same time fundamentals are actually improving. Even if long-term trends remain in place, such a setup can tilt the scales tactically and present opportunity.