August 28, 2014

We recently came across a great chart showing valuations for the stock markets of the US (blue line), developed international countries (orange line), and emerging market countries (green line):

Global stock valuations

To clarify, the chart isn't tracking performance, but shows valuations or "expensiveness"—the ratio of prices to their underlying fundamentals (in this case, 10-year average earnings). We've added a straight black line denoting the postwar median valuation for US stocks, to give an idea of what a middle of the road valuation would look like.

This chart provides an excellent snapshot of global stock markets. Some observations:

  • Global valuations have tended to move up and down together, but a major gap has developed since 2011, as the US market has gotten sharply more expensive while international developed valuations were relatively flat and emerging market valuations actually declined.
  • It's no coincidence that our own period of portfolio underperformance began when this gap started to open up. For going on 3 years now, the most expensive market has become a lot more expensive, while the less expensive markets stayed the same or got cheaper still. An investment strategy that seeks to buy underpriced assets and avoid overpriced ones is destined to fall behind during such times.
  • The good news is that, based on well-established market history, that valuation gap can be expected to close at some point. Should that happen, our value-conscious approach is likely to strongly outperform and to recoup much of the performance gap we've experienced.
  • It's important to understand that the majority of US stock gains since late 2011 have not resulted from improving fundamentals, but simply from prices being bid up, pushing the market from significantly overpriced to extremely overpriced. If the US market fails to remain highly overpriced, much of thatgainwill prove short-lived.
  • Putting some numbers on it: if the US market's valuation were to decline from its current level to the historical median valuation overnight, that would entail a price decline of 33% — wiping out 50% of prior gains.
  • Of course, nothing will revert to fair value overnight; the point is to illustrate the scale of the risk US stock investors are taking. We can also do this by looking at historical precedents. It's not visible on this chart, but US market has only reached this level of valuation during three prior periods: the late 1920's stock bubble, the late 1990's tech bubble, and the mid-2000's housing bubble. Each of those situations was followed by a market decline of at least 50%, and an eventual return below the median value denoted by the black line. There's no telling whether something like this will happen again, but poor long-term US stock returns are the very likely result of these sky-high valuations, regardless of whether they come in the form of a serious downturn or a longer period of minimal returns.
This is a major reason we are emphasizing those far more reasonably valued international stock investments in the portfolios right now. They allow us to participate in market growth without forcing us to depend on valuations staying at historically unsustainable levels. If valuations just remain at their current middle-of-the-road levels, we should make positive returns on those investments due to dividends and earnings growth over time. If values rise, better yet. Of course, valuations could go down too, but that would likely be temporary, as the market's strong tendency to "mean revert" (to return to average valuations) would be expected to bring them back up to normal value at some point.

That is the primary difference between US and international stocks right now: investors in the US market are betting that "this time is different," and that valuations will—for the first time ever—fail to eventually revert down towards a more historically average level. Investors in international stocks, which are already near their average levels, don't need to hope that this time is different at all.