The Kindness Of Strangers
Like Blanche DuBois, successful long-term investors can always rely on the kindness of strangers – strangers who, in financial markets, bid prices too high or too low as they give in to unwarranted enthusiasm or despair.  Over time, logic tends to reassert itself, rewarding those who bet against the prejudices of others.

With just two weeks left in the year, it appears that U.S. stocks are going to outperform international stocks in both emerging markets and other developed countries for the fourth year in a row, at least when measured in U.S. dollars.  Investors are always warned that past performance is not indicative of future returns.  However, judging by the behavior of markets in the last few weeks, this warning is falling on deaf ears, as U.S. stocks and the U.S. dollar have surged ahead since the election.  In short, it seems that global equity markets are pricing in everything that could go right in the U.S. and everything that could go wrong overseas.

In the United States, the now common rationalization for the post-election surge is that one-party Republican government will deliver economic stimulus, less regulation and lower corporate taxes.  All of this should boost after-tax earnings, justifying higher P/E’s today.

However, there are some potential problems with this viewpoint:

· First, it is doubtful that a new “stimulus” plan will significantly boost economic growth.  President-elect Trump’s fiscal agenda has the potential to push the debt-to-GDP ratio above 100% by the middle of the 2020s, something that Republican deficit hawks, (including his choice for Director of the Office of Management and Budget, Mick Mulvaney) may not be willing to accept.  In addition, Chair Yellen, in her press conference last week, noted that the economy was essentially at full employment.  If so, the major effect of fiscal stimulus would not be to raise output but to raise inflation and the Fed might well feel required to offset it through tighter monetary policy.

· Second, while Republicans are agreed on the need for a lower corporate tax rate, there is significant disagreement between the Trump plan, which calls for a cut in rates within the current system of corporate taxation and the House Republican plan, which would require companies to include imports and deduct exports from their tax base while also disallowing the deduction of corporate interest payments.  The end result of negotiations is highly uncertain.  However, any compromise that didn’t significantly reduce effective corporate tax rates would probably be less beneficial for stocks than the market is pricing in today.

· Third, the President-elect campaigned on a platform to limit illegal immigration and apply tariffs on imports from countries perceived to be taking advantage of the United States.  Higher tariffs would clearly increase inflation while a crackdown on immigration could worsen an already growth-stifling lack of labor-force growth.  It may be too optimistic to assume that the Trump administration will only implement those parts of his agenda that favor the market.

· Finally, the U.S. equity market is no longer cheap.  As of the close of business on Friday, the S&P500 was selling at 17.1 times future earnings compared to a 25-year average of 15.9 times.  While this is justifiable assuming continued below-average inflation and interest rates, these assumptions are beginning to be eroded.

By contrast, investors may be unreasonably negative on international stocks:

· The global economy is heating up.  The flash Manufacturing PMI numbers for December suggest that this may have been the best month for manufacturing around the world in over five years.  Moreover, both Europe and emerging markets have far more room to grow over the next few years than the U.S. due to still-high unemployment in the former and stronger natural productivity growth in the latter.

·  International stocks are generally cheaper.  The forward P/E ratio of the MSCI-EAFE index of developed country international stocks is 14.7 times compared to a 25-year average of 16.4 times.  The price-to-book ratio of the MSCI-EM index is 1.40 times compared to a 25-year average of 1.67.

· The dollar is too high.  In the third quarter, the U.S. ran a current account deficit of 2.4% of GDP.  We estimate that this should rise to roughly 3.3% of GDP by the end of 2018 or over $670 billion.  This growing deficit, combined with prospects for slower U.S. growth, should push the dollar down in the long run, amplifying unhedged international equity returns.

This is a time of year when many of us make resolutions for the year ahead.  When it comes to financial planning resolutions, two seem particularly relevant for 2017.  First, avoid home country bias – that is the tendency of investors around the world to be over-invested in securities of their own country.  Second, and even more important, when choosing what to overweight in a portfolio, don’t focus on past performance.  Instead look at current valuations and future prospects.  These valuations and prospects suggest more reasons for caution around U.S. stocks and optimism around international stocks than investors have demonstrated over the last few years and particularly over the last few weeks.

David Kelly is chief global strategist at JPMorgan Funds.