The Recent Rise of the U.S. Dollar
The U.S. currency gained in 2014 against all 31 of its major peers. The broad trade-weighted U.S. Dollar Index gained about 10% in just the last seven months (mid-2014 through January 2015). However, even with the recent surge, the dollar is only coming off historical lows, which occurred as the Federal Reserve kept interest rates extremely low for the past several years.
A different U.S. Dollar Index (which the Intercontinental Exchange Inc. uses to track the greenback against currencies of six trade partners) traded at about 94 last Friday. Still, this was lower than in 1985, when it exceeded 160, or even in 2001 when the index level topped 120.
Looking at even more long-term data from January 1973 to present, we find that the Federal Reserve’s Trade Weighted U.S. Dollar Index: Major Currencies, the Jan. 31, 2015 reading was 88.9, still below the long-term median of 94.0 and its long-term average of 94.5.
However, another Federal Reserve Index, Trade Weighted U.S. Dollar Index: Broad, with more limited data from early 1995 through early 2015, indicates a 2/4/2105 level of 114.2, above its median of 107.0.
Effect on U.S. Investors in Foreign Stocks
For U.S. investors in foreign stocks, the dollar’s rise contributes to a decline in the value of foreign equities (or, at least, contributes to a more modest rise in value than occurs for U.S. stocks, on average). While many other factors are at play which drive investor's returns, the dollar’s recent rise shows up as a factor affecting the comparable the returns of broadly diversified index funds:
- Vanguard Developed Markets Index Fund, Admiral Shares (VTMGX): 1-year return of -0.25%; 5-year average annual return of 6.51% (as of 1/31/15)
- Vanguard Emerging Markets Stock Index Admiral Shares (VEMAX): 1-year return of 9.21%; 5-year average return of 3.37% (as of 1/31/15).
- Vanguard 500 Index Fund, Admiral Shares (VFIAX): 1-year return of 14.18%; 5-year average annual return of 15.56% (as of 1/31/2015)
U.S. vs. Foreign Stock Valuation Levels
Concerns about U.S. stock overvaluations abound. As a result, some analysts predict very low U.S. stock returns (low single digits, typically) over the next 10-year period. (However, most analysts acknowledge that a wide variance in actual returns is possible, depending upon whether mean reversion occurs over the next 10 years.)
Many of these same analysts suggest, often by employing Shiller CAPE data, that slightly greater returns are likely in foreign developed markets stocks (on average). Some also opine that even better returns (albeit still single-digits) are probable in foreign emerging markets stocks (on average).
Yet, except for a few select countries such as Russia, Greece and Italy (all of which are undergoing major political and economic difficulties at present), most developed and emerging markets countries’ stocks don’t appear overly cheap – they are just not “quite as expensive” as U.S. stocks.
Expectations of Future Returns by Major Asset Classes
U.S. Equities. Over the past 88 years, U.S. equity investors have managed to generate real returns (after-inflation, but before taxes) approaching 7%, as measured by the CRSP 1-10 data set (i.e., a broad index of all U.S. publicly traded stocks, market-weighted). Nominal returns over the very long term approach 10%. It is possible that such average annualized returns will occur over the next 10-year period. However, prudent investment advisors are likely lowering the expectations of their clients for U.S. equity returns over the next 5-10 years.
U.S. Real Estate. Overvaluation may have occurred (as a result of speculation, and foreign investor’s cash flows) in real estate markets (particularly in several large U.S. cities). Indications exist that investors are turning toward secondary real estate markets, in search of higher yields. U.S. real estate, while it may have some demand-fueled near-term growth potential, does not appear particularly attractive at these yield levels.
Foreign Developed Markets. With much of Europe facing low economic growth over the coming year, and fears of deflation existing (although I believe such fears are overblown), European stocks appear more reasonably valued than U.S. stocks. But even with the recent rise in the U.S. dollar, I would not rate European stocks as “cheap.” At most I would rate them as "fairly valued."
Foreign Emerging Markets. By contrast, valuations in foreign emerging markets, on average, appear even more reasonably valued. While I would not call foreign emerging markets “cheap” – they do appear to be reasonably valued, both from a fundamentals perspective (various valuation ratios) and taking into account the recent rise in the U.S. dollar. Valuation levels for emerging markets stocks (collectively) appear to be about 10% to 20% below that of foreign developed markets (collectively). Not a huge bargain, but perhaps a slight bargain.
While emerging markets indexes are notorious for their “roller coaster ride” of price increases and decreases, the depth of market capitalization in emerging markets stocks has generally increased, leading to somewhat less susceptibility to wild price swings due to increasing or slacking demand for emerging markets stocks. Still, greater price volatility should be expected, relative to developed markets stocks.
Fixed Income. Rates for both corporate and government debt remain quite low. With a likely moderate increase in rates coming, interest rate risk appears to be large. Given the low yields currently, future returns for fixed income investments over the next ten years appear to be lower than for U.S. equities. Of course, fixed income investments provide not just a (low) contribution to an investor’s overall portfolio’s return, but also can provide stability to the portfolio – especially if shorter-term, high-quality fixed income investments are chosen.
What Should Investors Do?
Each investor’s situation is different, so no one answer is appropriate.
For investors undertaking withdrawals from their portfolio, a 5-year “buffer” – i.e., short-term, high-quality fixed income investments – appears appropriate. For example, if an investor is withdrawing 4% a year from their portfolio, a 20% slice set aside for future withdrawals appears appropriate.
The remainder of the portfolio might contain many different allocations, dependent upon individuals’ needs, preference, and tolerance/capacity/need for risk.
Of the equities portion of a U.S. investor’s portfolio, various investment gurus recommend anywhere from a 20% to 50% allocation to foreign equities, with the balance in U.S. equities. Although U.S. equities account for somewhat less than 50% of world (publicly-traded) stock market capitalization, I believe it is permissible to have such a home bias. I would recommend that somewhere between 25% to 40% of an investor’s overall equity allocation be committed to foreign equities. Of the foreign equities allocation, 25% to 40% could be allocated to emerging markets, with the rest to foreign developed markets.
For example, if an investor has a total investment portfolio of $1,000,000, a prudent allocation for a 60-year old soon-to-be retiree might be:
40% fixed income investments (with an emphasis on shorter-term, high-quality instruments);
40% U.S. equities
14% foreign developed markets equities
6% foreign emerging markets equities
Again, this strategic asset allocation is not for every investor. Some investors will need, or desire, to take on greater types of risk in their portfolios. Others will need to take on less risk. Investment time horizons need to be taken into account, along with other risks present which might be unique to each investor.
While the use of passive investment vehicles is also recommended, and a small cap and value tilt for the equities portion of the portfolio may be appropriate, these are the subjects for later blog posts.
For those who have already adopted a strategic asset allocation, rebalancing should occur on a targeted and/or periodic basis. In this manner, if the U.S. dollar continues to appreciate against other currencies, and/or if U.S. stock market valuations continue to increase, and/or if foreign stocks decline in value, investors can reap long-term benefits by purchasing at ever-cheaper valuation levels.
Ron A. Rhoades, JD, CFP® is an Asst. Professor of Business, where he teaches courses in investments, financial planning, and law. He is also the President of ScholarFi, Inc., a fee-only investment advisory firm. He can be reached at: email@example.com.