How will U.S. stocks perform versus foreign equity markets?

Reader's Question: Do you think the U.S. stock market will provide at least 10% to 20% returns over the next one to two years? Also, how about foreign equity markets?

I am bullish on equities over the long term and think it very possible that the U.S. stock market will see returns around the level you indicate. Negative factors--softness in residential real estate, sub-prime debt problems, possibility of recession, record high oil prices, weakening dollar--have potential to derail the current bull market and will continue to worry investors. Nevertheless, despite the short-term negatives, equity markets tend to exhibit a secular rise on the back of economic growth--and this long-term trend, with solid footing in our world's market economy and capitalism, is unlikely to subside anytime soon.

Think Global

Rather than focussing solely on U.S. equities, I would encourage you to think and invest globally, if you aren't already doing so. The pie chart below shows how the U.S. accounts for about 27% of the world's economy as measured by nominal GDP. This means that almost three-quarters of the world's economic output (i.e., the overwhelming majority of the pie) is generated outside of the U.S. Certainly, the U.S. remains the world's largest economy by a wide margin; however, rapid economic growth rates elsewhere provide a reason to look beyond U.S. borders.



Economic Growth Matters

The world's three largest economies--U.S., Japan and Germany--all have real GDP growth rates in the neighborhood of 2% to 3% annually. That's very sluggish when compared to high growth rates in many other countries among the world's largest 15 economies. Most notably, China continues to show robust 10% to 11% growth, India around 9% or 10%, Russia around 7%, and South Korea and Mexico about 4% to 5% growth. Since GDP growth in the underlying economy drives corporate revenue and earnings growth, which in turn determines stock price performance, it behooves us to focus in on high-growth countries.

As investors, we want growth, but we also want to make sure that we are not paying too much for the growth we get. A good way to gauge the cheapness or richness of entire stock markets is to look at the P/E ratios of representative ETFs. Barclays iShares manages country-specific ETFs that can serve as proxies for most of the largest economies. For example, one of their most popular ETFs is the FTSE/Xinhua China 25 Index (NYSE: FXI), which invests in H-shares of 25 large companies listed in Hong Kong and doing business in China. This China ETF has a market capitalizaion-weighted P/E ratio of 31, as of the end of September.

It is helpful to plot P/E ratio against GDP growth to develop an intuitive feel for how cheap or expensive the various stock markets are. In the graph below, I have drawn lines sloping upward from the origin for the four countries with the most attractive (i.e., lowest) ratios of P/E (for proxy ETFs) to GDP growth rate (for the corresponding countries). This composite ratio is a type of "PEG ratio" that measures P/E relative to growth, allowing for a quick comparison of low-P/E, low-growth and high-P/E, high-growth investment alternatives.



Observe how the ETFs of India (NYSE: INP) and China (NYSE: FXI) offer the most attractive PEG ratios, indicating that even though their respective stock markets are currently trading at relatively high P/Es of 23 (estimated) and 31, respectively, the double-digit (or near-double-digit) growth of their underlying economies appears to support their high-P/E valuations. The ETFs of Mexico (NYSE: EWW) and South Korea (NYSE: EWY) also show attractive PEG ratios.



Prospects for Growth and Profit

Although it is extremely difficult to predict which stock markets will rise the most over the next year or two, or whether the recent strength of global equity markets (particularly China and India) will continue in the near-term, I offer two suggestions:

1. Invest Globally: As a baseline when investing in equities, weight countries in approximate proportion to their contribution to world GDP. ETFs provide a means for taking on exposure to foreign equities while keeping costs and management fees low. Buying ADRs (U.S.-listed shares of foreign companies) is another way to go for those who enjoy (as I do) investing in individual companies. While U.S. equities may comprise the largest single-country contribution, all of the non-U.S. countries together should, in my opinion, add up to more than half of your overall portfolio.

2. Over-weight High-Growth Countries: Given their high GDP growth, China, India, Russia, South Korea and Mexico are good places to search for equity investments. Investors willing to take a long-term view and ride out the higher volatility of these markets stand to benefit from the tailwind that higher GDP growth provides.

Reporting this week of Mukesh Ambani and Carlos Slim's rapid ascent to the #1 and #2 positions in world wealth ranking (both appear to have edged out Bill Gates) is a sign of India and Mexico's strong economic growth and soaring stock market fortunes (as well as evidence of how concentrated wealth is among the super-rich in these countries of relatively low per-capita GDP). Also, Warren Buffett's investment in POSCO (NYSE: PKX) and other South Korean stocks is indicative of the potential upside this Asian market offers.

(Disclosure: The author does not currently have positions in any of the ETFs or stocks mentioned in this article but is overweight in non-U.S. equities from high-growth countries.)