Articles about stock market valuations are plentiful, shaping consensus views about relative value within global stock markets. The search term “U.S. stock market valuations are high” generates more than 2 million results; the search term “emerging markets are cheap” generates more than 2.5 million results.
Not coincidentally, the consensus view is that the United States is expensive and emerging markets are cheap.
However, as is often the case, headlines and a consensus narrative mask more subtle distinctions. Common misconceptions relate to the use of valuations for market timing and tactical asset allocation strategies, as well as the belief that valuations will revert to a long-term average. The cyclically adjusted price-to-earnings ratio, or CAPE, has attained almost mystical status since the dot-com bust and global financial crisis, but the CAPE is often misused. Although valuations provide important information, a review of misconceptions may help investors make better informed decisions:
Valuations are a viable tool for market timing. U.S. stock market valuations are above long-term averages, indicating that the market is expensive relative to history. Investors relying on valuation as a market timing tool are likely to be disappointed, as there is no evidence of a link between valuations and short-term performance.
[See: 9 Dividend Aristocrats for Stable Income.]
Valuations have more relevance to long-term performance, however, as there is a link between starting valuations and long-term results. Lower starting valuations have led to above-average stock market returns over subsequent 10-year periods, while higher starting valuations have led to below-average returns over subsequent 10-year periods.
Given today’s elevated valuation levels, it is reasonable to expect below-average U.S. stock market returns for the next 10 years. Although the next decade may bring returns that disappoint relative to the post-global financial crisis rally, it may be unwise to project a doomsday scenario in which returns are negative over the next decade.
Since 1945, the S&P 500 index has delivered positive average 10-year returns after a period of elevated valuations. The wide range of outcomes given an elevated valuation starting point highlights the limitations of valuation as a market timing tool, as in the best 10-year period the S&P 500 returned more than 9 percent per year and the worst 10-year period had returns of approximately negative 3 percent per year.
Staring valuations provide insight to help set return expectations, but high valuations aren’t necessarily a signal of an impending market crash and low valuations aren’t a guarantee of high returns.
P/E ratios will revert to the long-term average. Some investors expects price to earnings ratios to revert to lower long-term averages, a major potential headwind to U.S. markets helped by multiple expansion in recent years.
Important support for today’s P/E ratios comes from the persistently low level of inflation in the U.S. economy. The U.S. consumer price index has averaged approximately 4 percent during the past 50 years, about twice as high as reported inflation today. If inflation reverts to its 50-year average, the likelihood is higher that P/E ratios will also revert to their long-term average.
Some economists point to the influence of independent central banks, transparency brought by technology, and deflationary pressures from global trade to explain an environment in which inflation seems to have stabilized at lower levels than was the case from the 19th century until the 1980s. A lower-for-longer inflation rate could support P/E multiples that remain at above-average levels.
[See: 7 Emerging Market ETFs to Buy Now.]
The CAPE multiple signals impending doom. The Shiller CAPE is a P/E ratio based on inflation-adjusted earnings over the previous 10 years. The CAPE’s extended measurement period for earnings is designed to smooth out the impact of business cycles.
The Shiller CAPE is at a level only exceeded before the Great Depression and the bursting of the dot-com bubble. However, the CAPE ratio may be artificially high relative to history, as the 10-year moving average of profits includes the 2008-09 collapse of profits. When the global financial crisis-era profit decline is removed from the 10-year look-back window, the CAPE will decline by an estimated 3 points.
Changes in accounting rules are also a factor in today’s CAPE being less than fully comparable with the historical CAPE. Accounting changes in 2001 related to goodwill and intangible assets reduce reported earnings relative to pre-2001 accounting standards. According to BAM Alliance’s Larry Swedroe, “present values end up looking far more expensive relative to past values than they actually are. Adjusting for the accounting change would put the CAPE 10 about 4 points lower.”
The CAPE is undeniably at elevated levels, but arguably is less elevated than the headline ratio indicates. The CAPE, similar to traditional P/E ratios, is more of a long-term directional guide than a market timing signal.
The U.S. is expensive, emerging markets are cheap. U.S. stocks are expensive relative to history, but emerging markets stocks may not be as cheap as implied by headline valuations. Market-wide P/E multiples in emerging markets mask significant dispersion within the asset class.
Technology has become the largest sector within the MSCI emerging markets index, representing more than one-quarter of the index. Chinese technology stocks have been big winners, benefiting from the megatrends that have supported the growth and high valuations of the FANG stocks — Facebook (ticker: FB), Amazon.com ( AMZN), Netflix ( NFLX), Google ( GOOG, GOOGL) — in the U.S. Many Chinese technology companies sell at lofty valuations. Alibaba Group Holding ( BABA) and Tencent trade at more than 30 times projected forward earnings, Baidu ( BIDU) at more than 25 times and JD.com ( JD) trades at levels comparable to Amazon and Netflix.
The financial services sector, nearly one-quarter of the index, is a stark contrast as many of the leading bank stocks sell at mid-single digit P/E multiples. Given challenges including unresolved issues with bad loans, many analysts consider emerging markets banks to be justifiably cheap. Commodity stocks also trade at relatively low P/E multiples, which again may be appropriate given their cyclicality and a challenging operating environment.
Although it is still reasonable to think of emerging markets stocks as being less expensive than U.S. stocks, the gap narrows considerably after a closer examination of underlying valuation dynamics.
Averages can be deceiving, especially when valuations and historical returns are concerned. Understanding the nuances of valuation measures is important, as is understanding that there isn’t a precise relationship between valuations and returns.
[See: The 10 Most Valuable Auto Companies in the World.]
Disclosures: Registration with the SEC should not be construed as an endorsement or an indicator of investment skill, acumen or experience. Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal. Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable.
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4 Misconceptions About Market Value originally appeared on usnews.com
