The US stock market has trounced its international counterparts over the last decade, so much so that it is now looking decidedly pricey relative to European and global indices. Is it time to rotate into cheaper markets? Or does the US deserve its valuation premium?
Betting against the US has been a losing trade for many years now. In dollar terms, US stocks have beaten European equities by more than 100 per cent since the 2008 global financial crisis. As a result American stocks look expensive compared to most other asset classes. The differential is especially wide when one looks at Europe – according to Bank of America Merrill Lynch data the US is trading at a 40-year high relative to Europe.
At the same time there are always good reasons why some stock markets are pricier than others. Firstly, the main reason that the US has outperformed in recent years is because of earnings. US profits have easily surpassing their pre-financial crisis highs whereas European earnings have been largely stagnant over the last five years.
Secondly, the US has for many decades now been regarded as a stable, investor-friendly, pro-business country; as a result it has been traditionally rewarded with higher valuations.
Thirdly, the high-margin technology sector is much more important in the US than it is in other regions; adjust the US market for its sectoral makeup and the valuation gap will seem considerably narrower.
Then there is the question of what valuation tool to use. One of the most widely-used valuation metrics used to compare international stock markets is the cyclically-adjusted price-earnings ratio, or Cape, which averages earnings over a 10-year period. The US Cape ratio looks very high, both relative to its own history and to international stock markets. However, the ratio is an imperfect one. Structural US market changes mean the Cape is less accurate than it used to be, complain critics, who note that the indicator has signalled overvaluation for almost all of the last 25 years.
Still, US equities look expensive on almost all valuation metrics, not just the Cape, whereas most European and emerging markets appear relatively cheap.
As noted earlier, valuation of national stock markets must account for the question of sectoral composition. For instance, German outfit Star Capital, which regularly updates its analyses of the world's cheapest and priciest stock markets, notes that the Danish stock market appears extremely expensive but this is partly explained by the fact that the healthcare, pharmaceutical and biotech sectors account for 42 per cent of the Danish market, compared to just 9 per cent of the global market.
Similarly, the technology sector accounts for 18 per cent of the US market, compared to just 10 per cent for the overall global market. Additionally, the US is underweight with financial stocks, whereas the same sector has an outsized effect on European indices.
Adjusting for sectors changes the global valuation outlook. At the start of 2017 the Irish stock market’s price/book ratio was almost identical to that of the global stock market; if adjusted for sectors. However, Irish stocks appears 10 per cent cheaper than their global counterparts.
Russian stocks look cheap, but not nearly as cheap if one accounts for the fact that its market is dominated by commodity stocks. The Australian index appears similarly valued to global indices, but 28 per cent more expensive after one adjusts for sectors. The Chinese stock market appears to be the cheapest in the world, but the bulk of this apparent undervaluation is explained by its dependence on banking stocks.
Bargain hunters may be interested to know that adjusted for sectors the world's cheapest stocks can be found in South Korea, which traded at a 46 per cent discount to global indices at the beginning of 2017.
As for the US, its price/book ratio is 47 per cent higher than the global market. Adjusting for sectors significantly reduces this overvaluation, but it certainly does not eliminate it – US stocks remain 27 per cent higher than the global market.
Furthermore, Star Capital cautions that not only is the US overvalued compared to other markets and its own history, but the “magnitude of this overvaluation has rarely been higher”. Since 1979, investors had to pay on average 35 per cent higher prices for US stocks compared to European equities. At the beginning of 2017, that premium had grown to 60 per cent.
Saying that a particular stock market is expensive doesn’t guarantee that long-term underperformance will follow. The range of historical outcomes has been wide, and sometimes expensive stock markets go on to justify their valuations with further gains. However, Star Capital says that as a general rule, cheap stock markets go on to outperform expensive stock markets. It estimates that US stocks will deliver real annual returns of 4 per cent over the next 10 to 15 years, compared to 7.3 per cent for developed European stock markets and 8.2 per cent for emerging equities.
The “cheap beats expensive” theme is echoed by
Ritholtz Wealth Management
. Analysing US market returns since 1926, Carlson found that the cheapest periods were followed by annualised 10-year returns of 15.5 per cent. The more expensive stocks became, the lower future returns, with annual gains falling to just 3.9 per cent when stocks were valued at levels similar to today.
Looking at six different valuation metrics, he found that the non-US world is trading at a valuation discount ranging from 22 per cent to more than 100 per cent.
It’s little wonder that valuations look stretched given the huge American outperformance over the last five years. US stocks have returned 14.6 per cent annually over that period, compared to 6.5 per cent in Europe, 6.9 per cent in Asia and just 1.4 per cent in emerging markets.
Sceptics might note that these arguments have been made countless times in recent years, but the US has continued to defy the doubters just as Europe has failed to take flight. Still, while changes in global market leadership don’t operate on a set schedule, no region dominates forever. Since 1970, European and US stock market returns have been almost identical, with both regions dominating in different periods.
In the short-term none of this matters – anyone looking to know where stocks will be in 2018 needs not concern themselves with valuations.
It’s a different story for long-term investors, however. With the US looking expensive, and relative value to be found in Europe and emerging markets, the next decade may be kinder to those investors who refuse to chase performance.