Larry Swedroe takes a look at U.S. and international equity valuations, and what the differences between them mean for investors.
With the Shiller CAPE 10 above 30 (to be precise, 30.7 as I write this), it’s likely you have seen an interview or read an article in which some “guru” claims the market is on its last legs due to excessive valuations.
Certainly, current valuations are high relative to their long-term historical averages, which means forward-looking return expectations are lower. However, that doesn’t necessarily mean the market is overvalued, just relatively expensive.
To get a better idea of how expensive U.S. equities are, I’ll compare today’s valuation metrics to some longer-term averages as provided by J.P. Morgan Asset Management in its third-quarter 2017 Guide to the Markets. Current data for the Vanguard S&P 500 ETF (VOO) is from Morningstar as of Aug. 31, 2017.
While today’s forward-looking price-to-earnings (P/E) ratio is higher than the 25-year average, the dividend yield is the same as its 20-year average, and the price-to-book (P/B) ratio is the same as its 25-year average.
In terms of forward-looking real returns, we can use the CAPE 10 earnings yield and the current earnings yield—they have approximately the same explanatory power for 10-year returns.
Using the CAPE 10 provides an estimate of real returns of 3.3%. Using the current P/E provides a higher estimated real return of 4.9%. With a negative current real yield on one-month Treasury bills, that still offers investors a fairly large equity risk premium. Thus, it seems to me, it’s hard to argue that markets are overvalued; rather, they are just more highly valued than has been the case historically.
What About The Rest Of The World?
Because investors are not limited to investing only in U.S. equities, I’ll examine global equity valuations so that we can see how expensive they are in comparison. And I’ll also look at their forward-looking return expectations.
Historical data is from J.P. Morgan Asset Management’s third-quarter 2017 report, and current data is from Morningstar as of Aug. 31 using the Vanguard FTSE Developed Markets ETF (VEA) for the non-U.S. developed markets, the Vanguard FTSE Europe ETF (VGK)for Europe, the iShares MSCI Japan ETF (EWJ) for Japan and the Vanguard FTSE Emerging Markets ETF (VWO) for emerging markets.
As you can see, valuations outside of the United States are quite a bit lower, and they look more favorable relative to their 25-year averages. In the case of emerging markets, although J.P. Morgan did not provide the P/E ratio’s 25-year average (the current P/E of VWO is 14.2), it did provide the P/B ratio’s 25-year average. It was 1.7, the same as it is today for VWO.
We can also examine the relative valuations of U.S. and international stocks from the perspective of P/B ratios. The current P/B of U.S. stocks (VOO) is 2.9 versus just 1.6 for VEA, 1.8 for VGK, 1.4 for EWJ and 1.7 for VWO. Again, we see U.S. valuations are much higher.
In terms of forward-looking return expectations, we can use the same two methods we did for the U.S. calculations. The current CAPE 10 for U.S. stocks is 30.7, providing an earnings yield of 3.3%. Using data from AQR Capital Management, as of June 30, 2017, the CAPE 10 earnings yield for developed markets was 5.4% and for the emerging markets it was 7.0%.
Those are the forecasted real returns. Using the current earnings yield, the forecasted real return is 4.9% for the United States, 6.6% for developed non-U.S. markets, 6.3% for Europe, 7.1% for Japan and 7.0% for emerging markets.
Either method provides forward-looking return expectations for international stocks that come in about 2 percentage points higher than for U.S. stocks. In addition, those higher forward-looking return expectations are much closer to their historical averages than is the case for U.S. stocks, where the expected real return is well below the historical 7%, especially when using the CAPE 10 methodology.
No Free Lunch
It’s important to recognize that the higher forward-looking return expectations for international stocks are a result of investors expressing their belief that investing in U.S. equities is safer than investing internationally. Thus, higher forward-looking return expectations should not be viewed as a free lunch.
However, investors seeking to increase the forward-looking return expectations of their portfolios can do so by increasing their international allocation rather than by increasing their overall allocation to equities. Doing so would also provide a diversification benefit insofar as it would diversify economic and geopolitical risks associated with investing in U.S. equities.
Today, despite the fact that U.S. equities only make up about 50% of the global market capitalization, on average, U.S. investors hold much higher allocations of U.S. stocks, reflecting the well-documented issue of home-country bias.
All over the world, there’s a strong tendency for investors to believe their country is a safer place to invest and that their country will provide higher equity returns. Those beliefs are inconsistent, as safer investments should have lower, not higher, forward-looking return expectations. And of course, not every country can be the safest or the one with the highest returns.
The long market rally since March 2009 has resulted in a world where there are no equities that appear to be cheap (that is, have historically low valuations).
However, while U.S. valuations are relatively high, international equity valuations appear to be much more in line with long-term averages, providing investors with higher, though not guaranteed, forward-looking return expectations.
Because large-cap stocks are only one equity asset class among many, I thought it worthwhile to show the relative valuations of other asset classes. I’ll use funds from Dimensional Fund Advisors (DFA) to do so, as the firm offers a broad array of international asset class funds. That allows us to compare U.S. stock valuations to developed and emerging market stock valuations in the same broad asset classes: small, large, small value and large value.
The following table shows current value metrics (price-to-earnings and price-to-book ratios) as of Aug. 31. Data is from DFA. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends DFA funds in constructing client portfolios.)
Once again, across all asset classes, U.S. stocks have much higher valuations than both international and emerging market stocks. And as you should expect, international stocks have much higher valuations than emerging markets stocks. The lower valuations of emerging market stocks (and their higher forward-looking return expectations) reflect their riskier nature, for which investors demand a risk premium.
This commentary originally appeared October 11, 2017 on ETF.com.
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