Even though the U.S. stock market is grinding higher, its lofty valuation is a red flag. Where else around the globe can investors look for better values?
New York is the center of the world …
… at least that’s how many New Yorkers feel.
Some of you older readers may recall this classic cover from The New Yorker, which captures this New York-centric view of the world.
(By the way, notice that price! Just $0.75!)
In the same way, a great many U.S. investors believe that the U.S. is the center of the investment world.
And of course, that makes sense — we’re most familiar with the U.S. markets, as well as so many of the domestic companies that trade on them.
Plus, the U.S. markets have been enjoying an historic bull market in the wake of the financial crisis. The S&P has climbed 300% since March 2009.
So, it makes perfect sense why our investment focus would be here at home.
But …
It’s a great big world out there. And while it surprises many investors, the U.S. stock market is not always the best place to be invested. In fact, buying your average, bread-and-butter S&P 500 stock right now is probably not the best place to put your money if you have a long-term investment horizon.
Why?
Well, let’s say you wanted to invest in a rental property. You’re evaluating two options.
With Option A, you have a home in an upscale neighborhood. But its purchase price is very high — in fact, even relative to other expensive homes in that neighborhood, the price is higher than average.
With Option B, the rental home is in a modest but up-and-coming neighborhood. But the home you’re considering has an inexpensive price tag — even relative to other inexpensive homes of its type within that neighborhood.
Which one sounds like the better value?
It’s Option B, for one simple reason — the price you pay for an investment matters.
Right now, the U.S. market is similar to the “upscale” home. Meanwhile, there are a number of other stock markets around the world that approximate the more modest home.
It would benefit all of us to take notice of these non-U.S. opportunities. After all, it was Warren Buffett who famously said “price is what you pay, value is what you get.”
So, in today’s Digest, let’s take a closer look at the connection between the price you pay and future returns. Then let’s widen our gaze, looking beyond just the U.S. stock market to see what other “deals” are out there around the globe.
***The price you pay has a huge effect on your long-term returns
Let’s start with how we’re going to measure “price.”
For our purposes today, we’re going to use the “Shiller PE ratio” developed by Yale professor, Robert Shiller. It’s also known as the “CAPE” ratio, which stands for cyclically adjust price-to-earnings” ratio.
In essence, it’s a long-term measure of a market’s valuation that seeks to smooth out shorter-term irregularities.
Here’s some long-term context for where the U.S. stacks up today on a CAPE basis.
Does our current level look high to you?
It is.
Now, it’s not nosebleed high, like we saw at the peak of the Dot-Com mania, but we’re clearly at elevated levels. The U.S. CAPE is trading at 29, while its long-term average is 16.6.
Let’s put this in “shopping” terms …
When go to the “market” store, the U.S. market costs — on average — about $16. But today, it’s selling for $29. Does that sound like a good deal to you?
Let’s now shift our focus to “return” to see what might happen if you decided to buy at this level regardless.
***The higher the buying price, the lower the future return
Markets tend to gravitate back to their long-term averages over time.
So, a country that has a high CAPE value today is more likely than not to see its value fall in the coming years. The underlying dynamic that would cause this is below-average stock returns.
On the flip side, a country that has a low CAPE value today is more likely to see its value rise in coming years. And that would be due to above-average returns.
This is the basic ebb and flow cycle that’s been a part of the financial markets since they began.
Now, one takeaway from this cycle is that the more extreme the starting CAPE value (either high or low), the more pronounced those future 10-year returns often are.
Below is a chart from Meb Faber, a highly-respected quant investor. Starting in 1900, the chart shows initial CAPE values and what the 10-year returns ended up being based on those starting CAPE values.
Dark green represents the cheapest CAPE starting years. Red represents the most expensive.
As you’ll see visually, most of the “green” starting years (low CAPE ratios) end up on the right side of the chart — meaning big 10-year returns.
On the flip side, “red” starting years (high CAPE ratios) usually end up on the left side of the chart — meaning low and negative 10-year returns.
While we can’t say it always works this way, it usually does.
Now, remember, as I write, the U.S. Shiller CAPE Ratio is at 29 — which puts it deep into those “red” starting years.
Conclusion?
Odds suggest the broad U.S. stock market will significantly underperform over the next decade.
***Continuing to invest in the broad U.S. market is a bit like playing a risky hand of blackjack
Let’s say you’re in Vegas at the blackjack table (where the goal is for your cards to add up to an amount as close to “21” as possible without going over). You’re sitting on 18. The dealer’s face-up card is a 6. Are you going to hit?
Unlikely — the mathematical probabilities behind you getting a “2” or “3” card are slim.
But let’s say you threw caution to the wind and did ask for another card. It turns out the gambling gods are on your side, and you get that 3. Blackjack!
Does that mean you made a good bet?
Of course not.
In the same way, is betting that the broad U.S. market will continue to climb from this level for many years a good bet?
Not if we go by historical valuations.
Statistically, the safer bet is “pull back” on the U.S. and look around the globe for markets with better starting valuations. Of course, that doesn’t mean the U.S. markets won’t continue climbing despite lofty valuations. And, of course, a bullish investor could make that bet — and win. But that doesn’t mean it’s a good wager.
Here’s how I visualize this dynamic right now. Below, the squiggly line (not to scale) represents U.S. valuations. We’re at the point where the black line stops.
So, at this current level — and evaluated from a long-term perspective — are we more likely to follow the green trajectory or the red one?
Please understand, this doesn’t mean certain thematic investments aren’t going to soar from here (think 5G, marijuana, artificial intelligence, self-driving cars, and so on). I’m referring to the overall broad market.
***So, what other stock markets around the world offer lower starting valuations?
We can turn back to Meb Faber for help on this. He compiles data from stock markets around the world to arrive at global CAPE ratios (Meb tracks developed and emerging markets, but not frontier markets).
Let’s actually start with the most expensive countries. That will give us a little more context.
If we sort all the countries in the world from cheapest to most expensive, then divide them into quarters, the most expensive 25% currently have a median CAPE of 28.
Below are the top 20 most expensive countries. Note where the U.S. comes in with its CAPE of 29.
On the other hand, the cheapest 25% of countries have a median CAPE of 17.
Here are the 20 least expensive:
As we wrap up, yes, the U.S. stock market is still grinding higher — the Dow is up 400 points as I write, based on trade talk optimism. And who knows, it could defy valuations and keep climbing far longer than anyone guesses.
But if you go by history and mathematical probabilities, the S&P isn’t likely to be the best place for your money over the next decade.
If you look around the world, there are a number of stock markets offering much lower valuations. Of course, a low valuation doesn’t mean these markets are going to begin climbing tomorrow. But on a long-term basis the odds are in your favor.
Think of it this way — if you’re sitting at the blackjack table and you have to take another card, would you rather be holding 12 or 18?
Have a good evening,
Jeff Remsburg
