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What history tells us about the future performance of international stocks

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Many retirees are giving up on international stocks. Is that a good idea?

One argument in favor of giving up is that the large-cap stocks dominating the U.S. stock market have themselves become globally diversified, so a “domestic” index such as the S&P 500
SPX,
+1.18%

 in fact already represents a healthy allocation to non-U.S. markets. Currently, for example, about a third of the revenue for S&P 500 companies comes from outside the U.S., and in some recent years this proportion was above 40%.

Another reason many advance for giving up on international equities is that the category has been such a disappointing performer in recent years. Over the last decade, for example, the S&P 500 has produced an annualized total return of 13.7%, nearly triple that of the 5.4% annualized total return of MSCI’s Europe, Australasia and Far East (EAFE) index.

Giving up on international equities may be premature, however. You could just as easily argue that, because U.S. equities have become so overvalued, relative to global stock markets, their expected returns going forward are now among the lowest. Consider the Cyclically-Adjusted P/E Ratio (or CAPE) made famous by Yale professor Robert Shiller. The U.S.’s CAPE currently is higher than any of 25 other developed nations’ stock markets.

Unless global equity markets have permanently changed, therefore, it might be hazardous to extrapolate the recent past into the future. The four most dangerous words on Wall Street, as we all know, are “this time is different.”

For this column, I have analyzed the relative returns of the S&P 500 and the EAFE index back to when the EAFE was created in 1969. My implicit assumption in conducting this analysis is that the long-ago decades are just as relevant as more recent ones.

The accompanying chart reports what I found. I created six hypothetical portfolios that differed only according to the relative allocations to the S&P 500 and to the EAFE Index. At one extreme was a portfolio that was 100% allocated to the S&P 500 and 0% to EAFE, and at the opposite extreme was another portfolio that was 0% allocated to the S&P 500 and 100% to the EAFE. There were four additional portfolios with differing relative allocations in between these two extremes.

Focus first on the blue bars, which reflect the annualized returns of these six portfolios. Notice their remarkable consistency: When rounded to the nearest whole percentage point, they all produced annualized returns of 12%. Assuming the future is like the past, this means that the long-term return of your equity portfolio will not change much according to how much or little you allocate to international stocks.

That’s not the end of the story, however, since improving returns is but one of the reasons to divide your equity portfolio between these two categories. Another is to reduce risk, of course. Since domestic and international stocks are not perfectly correlated with each other, a portfolio diversified among both should have lower volatility than one allocated totally to one or the other.

This is only partially true, however. The three portfolios that had 60% or more allocated to international equities were more volatile than the other three that had 40% or less international allocated. The portfolio that had the lowest volatility risk was the one that allocated 80% to the S&P 500 and 20% to the EAFE.

As a result, this portfolio’s Sharpe Ratio—a measure of risk-adjusted performance—was the highest of the six. If we were forced to draw an investment implication, we’d therefore conclude that you should allocate 20% of your equity portfolio to non-U.S. stocks.

As you ponder this investment implication, however, it’s helpful to bear in mind the joke about how you can know if an economist has a sense of humor. The answer: He uses decimal points. This joke serves as a funny—but important—reminder that it’s all too easy to succumb to false precision.

Consider the degree to which the 80% domestic/20% international portfolio beat the 60%/40% portfolio. The Sharpe Ratio for the former is 0.73, versus 0.71 for the latter. Given that the difference between these two is so small, and given that there is so much noise in the data, a statistician would not be able—at the 95% confidence level—to conclude that the 80%/20% portfolio was a significantly better performer.

This will have implications when we discuss the other major finding of my analysis.

Regression to the mean

A corollary of my findings may not be immediately obvious. But the remarkable consistency in the returns of my six portfolios implies that periods of S&P 500 outperformance over the EAFE are typically followed by periods of underperformance—and vice versa.

I quantified this by calculating the correlation coefficient between the S&P 500’s performance relative to the EAFE over the trailing 10 years and its relative performance over the subsequent 10 years. The correlation coefficient ranges from a theoretical maximum of 1 (when the two series move up and down in perfect lockstep with each other) to a minimum of minus 1 (when the two move perfectly inversely to each other). For these two data series, the coefficient is minus 0.53, which is statistically quite significant.

What this means, on the assumption the future will be like the past: Because the S&P 500 so outperformed the EAFE over the last decade, more likely than not it will underperform over the next decade. The implication for investors today is a contrarian one: Far from writing off international equities because of their poor performance over the last decade, you might want to overweight them going forward.

This investment implication becomes especially compelling in light of what I discussed above about the small performance differences between my hypothetical portfolios.

The bottom line? By no means should you give up on international equities. And you might even want to overweight them going forward.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com.



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These money and investing tips can help you stay upright against the market’s headwinds

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Don’t miss these top money and investing features:

These money and investing stories, popular with MarketWatch readers over the past week, can give you greater knowledge about the financial markets’ current condition as you monitor your portfolio and plan ahead. Plus, check out several short videos about whether to include bitcoin and other cryptocurrency in your portfolio and how to go about it if you do.

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Opinion: I took advantage of the 2020 RMD rule but now my 1099-R looks wrong — what should I do?

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Q: I took advantage of the 2020 RMD rule and returned what I had taken from my IRA thinking there would be no taxes. I just got a 1099-R showing the full RMD. That can’t be right. How do I correct it?

—Pauline

A.: Pauline,

If the 1099-R is incorrect, you will need to contact the firm that issued the statement to get it corrected. However, the 1099-R is probably correct.

Read: Are there new RMD rules this year?

Under the law, the firm issuing the 1099-R has no responsibility for reporting how much of a distribution is taxable. That responsibility rests on your shoulders as a taxpayer. The issuing firm need only report what was paid out of the IRA on 1099-R.

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That does not mean you will pay any tax. Any funds returned to the IRA by Aug. 31, 2020 is considered a rollover and is not taxable. Normally, Required Minimum Distributions (RMD) are not eligible for rollover, but IRS guidance after enactment of the CARES Act that waived RMD for 2020 changed that. The guidance stated the normal 60-day time limit for rollovers would not apply and instead instituted a fixed deadline of Aug. 31, 2020 to return such distributions and avoid taxation.

Read: It’s not too late to save on your 2020 tax bill — here’s how

I get similar questions about 1099-Rs every year. The reporting of the gross distribution looks like an error but in most cases, it is correct and the person receiving it simply hasn’t learned how it is accounted for yet.

Here’s how the accounting typically works.

As with any gross amount reported on Form 1099-R, you declare the amount that is not taxable when you file your 2020 tax return. What I hear most tax preparers would do in your situation is put the gross distribution amount from 1099-R on line 4a as per the normal procedure. Then, they would place a zero in 4b of your Form 1040, and put a note on the return near those lines that it was “returned to the IRA under the CARES Act,” “CARES Act rollover,” “CARES Act,” or simply “Rollover.”

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If you did not return all of distribution by the deadline, the portion that was not returned would be taxable. You would put that number on line 4b.

Read: 5 things to do if you inherit a Roth IRA

As I mentioned a moment ago, the discrepancy between the gross distribution reported and what should actually be taxable comes up in other situations. Three of the most common are other rollovers, Qualified Charitable Distributions (QCD), and distributions from accounts that had received after-tax contributions.

In all those cases, the reporting process looks like what I described above. You put the gross distribution on line 4a and the taxable portion on Line 4b. Then note why the numbers are different with “rollover,” “QCD,” or “See Form 8606” on the 1040. Form 8606 is the form used to determine the taxable amount of an IRA distribution when nondeductible contributions have been made to any of one’s IRA accounts.

If you have a question for Dan, please email him with ‘MarketWatch Q&A’ on the subject line.

Dan Moisand’s comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.



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Video: Why Mike Novogratz sees bitcoin reaching $500,000 by 2024

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Galaxy Digital’s Mike Novogratz explains the outlook for crypto as Coinbase goes public.





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