It is ironic that the relative strength of international stocks versus U.S. stocks bottomed right when the “Make America Great Again” president was inaugurated. But that is exactly what happened. There has been a wide performance disparity that has emerged this year between the U.S. and many international markets, including Europe, with U.S. markets underperforming.
Are we missing something? Should we add overseas investments now, including Europe, if for no other reason than to diversify away from the U.S. drawdown in stock prices? In a word, no. Europe, for example, offers little growth. Sure, valuations are cheaper, but they should be because of the lack of growth in real GDP and earnings. In fact, Germany and the U.K. are showing negative real GDP growth this quarter. Many international markets have been strong partly because U.S. advisors are advising their clients to invest abroad. Keep in mind this is the first time many international markets have outperformed the U.S. since 2008.
We are a U.S.-centric manager. We are not against buying international stocks (via American Depository Receipts or ADRs), but will do so only if the fundamentals and valuation are extremely attractive. We have owned a number of international stocks over the years but look to invest in the U.S. first. This is where there is growth.
WHAT JUST HAPPENED?
There is almost always a fundamental concern that starts a correction (10% off a high), something the bears can sink their teeth into. This time it is tariffs and a trade war. While most businesses and consumers would likely agree with the overall objectives of the Trump administration, it has been difficult to sometimes make sense of proposed actions, creating a level of uncertainty around the economy not seen since COVID five years ago.
Investors have two primary fears about the potential results of tariffs: the possibility of recession and higher inflation. Many investors see a trade war slowing growth for all participating countries, including the U.S. The fear is this will result in a U.S. recession. Second, tariffs are a tax on the consumer so they may result in higher U.S. inflation, tying the hands of the Fed and possibly delaying further rate cuts. Some even think the Fed may have to reverse course and raise rates to battle higher prices. And then there is the possibility of both recession and higher prices resulting in stagflation – the worst case scenario.
Are these fears justified? First, with regard to recession, we don’t think so. The economy is slowing but still strong. To go from mid-2% real GDP growth in 2024 to sub-zero growth would be surprising, absent an event like COVID. Many reputable economists on Wall Street are downgrading 2025 U.S. GDP growth from a consensus of 2.2% to 1.7%, hardly in recession territory. As far as inflation, yes, short-term inflation will probably rise if producers don’t eat the tariffs. This is what we are concerned about, not recession.
This seems to be a classic example of the market leaping to a worst-case, low-probability scenario. Shoot first, aim later seems to be the motto of the market. The fears are overdone in our view, and so is the market turbulence. After three-plus weeks of decline, the market is grossly oversold. This means the market is overdue for a snap-back rally. Maybe last Friday was the start of it.
Jittery investors are forgetting that fundamentals, earnings growth, and valuation are all attractive here. Yes, the economy, including jobs growth, is slowing but still healthy. Unemployment remains at 4%.
Earnings growth projections are solid: 11.5% for 2025 and an accelerating 14.2% for 2026. As a result, valuations are reasonable here. Here is a valuation recap:
Approximate Forward Price/Earnings Ratios
2025 2026
S&P 500 19.91 17.5
S&P 493 (ex-Mag 7) 17.0 15.0
1down from 21.5x at 2024 year-end
Source: FactSet
The Mag-7 stocks have higher-than-market forward P/Es (high 20s), but projected earnings growth is much higher for Mag-7 stocks. The remaining S&P 493 stocks have lower P/Es than the overall market.
These P/E ratios compare to the five-year average of 19.8x and the 10-year average of 18.3x. Stocks are at attractive levels from our point of view.
It is also interesting to us that investor sentiment is on its back. The recent AAII release (American Association of Individual Investors) showed bearish sentiment above 55% for the third straight week which has occurred only one other time – right before the March 2009 low. Fortunately, sentiment is considered a contrarian indicator meaning bearish sentiment would imply stronger forward returns and vice versa.
Bull markets that make it two years typically last an average of five. The year after the second anniversary has tended to be relatively weak, like now. The second anniversary of this bull market was five months ago and following the trend, the market has run into turbulence. Long-term investors should stay invested even during corrections. To ensure competitive returns over many years, investors need to participate on the strong up days, like last Friday. The big up days account for a large part of returns. For example, the 10 biggest up days in 2024 accounted for 20% out of the S&P 500’s 23% return.
We are buyers of stocks here, not sellers. Long-term returns improve when you buy stocks that are on sale. There are a number of high quality growth stocks 15-25% off their 52 week highs. We are finding attractive new ideas as well as adding to existing holdings that have been caught up in the recent market correction.