May 22, 2015

This is a follow-up to our prior article, The Rising Tide of Economic Progress, and Why it's Rarely “Different This Time.”  Here's a quick recap:
 
Below, we will use this framework to drill down into the three major areas of global stock markets: US, international developed, and international emerging. For each one, we'll provide some background, discuss long-term prospects, and address some popular viewpoints that have had investors overly focused on the short term or thinking it's "different this time."

International Developed Markets
 
Description Non-US countries with relatively wealthy and highly developed economies
Share of global economic activity 39% 2
Share of global stock market capitalization 39% 3
Top 5 countries by market capitalization Japan, UK, France, Switzerland, Germany 4

Long-Term Prospects

Viewed through the lenses of current valuations and long-term earnings trends, stocks in developed international economies look pretty good. Developed market (DM) stock markets are on average priced slightly higher than their historical norm5, but still at a level that has typically delivered significantly positive long-term returns. There are some DM stocks with better pricing and expected returns than the average. (We'll get more into specific expected returns later).

While DM economies have seen sluggish growth in the aftermath of the financial crisis, we don't see this as a permanent state of affairs. As we discussed at length in the last article, it's very likely that these economies will eventually revert towards more normal rates of growth, as they always have after past episodes of weakness.

Based on those factors, developed market international stocks look like a good option for long-term investors.

Popular View

Despite the seemingly positive long-term outlook for international developed market stocks, we hear a lot of negativity about them. Most of it focuses on Europe, so we will address some of the most common Europe-related misgivings below.
 
Popular Viewpoint Our Thoughts
European economic growth has been weak / Europe could go into recession Actually, European economic indicators have been strengthening — for example, Markit's Composite Eurozone PMI recently hit a 4-year high.6 There are several reasons, including improving economic data, rising sentiment, and supportive central bank policy, to be optimistic that the rebound in Europe's economy might persist.

But that's actually beside the point, which is that it doesn't matter what the economy is doing right now. We can't emphasize this enough. Stocks are a share of the long term stream of earnings, so what we care about is that long term future stream, not what's happening this moment or in the near future. Slow growth is absolutely not a reason to forgo owning reasonably valued stocks — in fact, economic slowdowns are often the best time to buy stocks, as that's when they are likely to be cheaper.7

As for recessions, they are a natural part of the economic cycle and the potential for a recession is not a valid reason to avoid stocks. If recessions could be accurately predicted that might be another story, but they can't — witness all the late-2014 calls for European recession, which now appear to have been wrong. As long as stocks are not highly overpriced to begin with, any losses during a recession can reasonably be expected to be recovered after the recession ends.

The "rising tide" pictured in the chart of global economic growth we included in the last article includes slowdowns and recessions as well as the booms. They are just part of the process, and nothing to be feared for long-term investors in reasonably priced stocks.
Greece could exit the European Monetary Union, resulting in economic chaos A Greek exit from the Euro is a possibility, but it's an open question how much chaos that would cause for the rest of Europe. Greece is after all a very small economy, and the Europeans are much better prepared for a Greek exit than they were when the Greek debt crisis began several years ago.

Even if it does happen and is worse than expected, we don't see this issue as a reason to avoid a long-term investment in European stocks. A Greek exit could possibly cause temporary economic or market volatility, but it's hard to imagine that it could significantly alter the long-term course of economic growth, such as that pictured above — which is what we are concerned with.
Europe is near deflation, so they could have a deflationary lost decade like Japan We don't hear this one so much now that the European Central Bank has embarked on QE, but it was sure popular late last year. It's actually a very misguided concern, because while deflation was present during some of Japan's "lost decade" in the 1990s, it wasn't the cause. Japan's economic troubles began with the simultaneous bursting of epic bubbles in both stocks and real estate. Japan's woes resulted not from deflation, but from the bursting of two immense bubbles that bore no resemblance to anything that's going on in Europe. This comparison just doesn't make much sense.

With regard to deflation in general, we think that mild deflation is not the disaster it's often portrayed to be, and as with all things it would likely be temporary anyway. As for the possibility of more serious deflation, it should be clear by now that the European Central Bank is willing and able to "do whatever it takes" to prevent that from happening.
Europe needs to address the structural issues that result from having multiple economies under the same monetary policy This is definitely true. The European Union faces a number of long-term challenges (although, the same could be said for the US and pretty much any other country).

But we don't see this as a sound reason to entirely reject investing in Europe. Of course there are risks, challenges, and uncertainty — these are ever-present, and if it weren't for them, stock markets wouldn't offer anywhere near the kind of returns that they do. The answer is not to avoid risk altogether (this would be impossible anyway), but to diversify and to ensure that expected returns are commensurate with risk.

Europe doesn't have to hit it out of the park in order for European stocks to do well. This is because of valuations: a fairly mediocre outcome is already "priced in" to the stock market. All that is needed is for Europe to muddle through and to eventually get growth back to the vicinity of its long-term trend. Europe faces its share of challenges, but we think European stock valuations and long-term prospects are good enough to warrant their inclusion in a diversified investment portfolio.
 
International Emerging Markets
Description Countries that are less wealthy, or have less developed economies, than the rich-world "developed market" countries.
Share of global economic activity 39% 2
Share of global stock market capitalization 22% 3
Top 5 countries by market capitalization China, South Korea, Taiwan, South Africa, India 4

Long-Term Prospects

Emerging Market (EM) stocks have had a rough several years. They have yet to recover to pre-crisis levels, and even in the post-crisis period, EM stock prices have gone nowhere since 2010.1

But that poor performance has been mostly due to a decrease in valuations, not to economic fundamentals. The decline in valuations has left EM's quite reasonably valued, with some segments of the EM stock markets actually undervalued.5

The chance to buy into the economic "rising tide" at not just reasonable, but cheap valuations doesn't come along all that often (not recently, anyway). This is the kind of opportunity that long-term investors should embrace with enthusiasm!

Popular View

And yet, because of their poor performance in recent years, EM stocks are very unpopular these days. (This is a great example of the tendency towards extrapolation that we mentioned above).

Here are some common concerns:
 
Popular Viewpoint Our Thoughts
Emerging market economic growth has been subdued Yes, this is true. Rates of EM growth have backed off of their previously rapid pace. But emerging markets on the whole are still growing, and are doing so faster than the developed economies. The IMF forecasts that EM economies will grow 4.1% in 2015, compared to 3.4% for the US and 2.7% for the developed world as a whole.8

It's not that emerging market growth is bad, but that it's been disappointing. Investors' expectations got too high as they assumed fast growth was permanent (again, extrapolation), and they've had to adjust their expectations down to reality.

But at this point, expectations have adjusted so far that they now seem to be erring on the pessimistic side. As a result, areas of the EM stock markets are undervalued, which suggests that investors could get an extra performance boost if markets eventually return to pricing in normal levels of growth (which, if history is a guide, they very likely will).
There is more risk and uncertainty in EM's This is also true, in that there seems to be more geopolitical and other "real world" risk in a given EM country than in a developed country such as the US. However, there are several mitigating factors.

First, we take a highly diversified approach to our EM exposure, which greatly reduces the impact of country-specific risk.

Second, considering our positive outlook for EM stocks, we actually have fairly modest level of exposure. We do this purposefully, in light of EM stock's higher volatility and potential uncertainty.

Third, to the extent we are taking risk in EM stocks, we are being compensated for it. Remember, good investing is not about avoiding risk altogether, but about being well compensated for the risk you are taking. We believe that to be the case with EM stocks, and as we'll discuss later, prospective returns for EM's are significantly higher than any other area of the stock market.

Generally, we think it's outmoded to view EM stocks as an exotic or particularly risky investment. At this point, emerging markets account for 39% of world economic activity and 22% of global stock market capitalization.2,3 They are simply a huge part of the global economy and markets, and they aren't going anywhere. It's entirely reasonable to include them in a diversified investment portfolio.
Fed tightening could be bad for EM stocks The strange thing about this objection is that it seems to imply that expansive Fed policy has been great for EM stocks. But it hasn't, at least not any time lately: despite the intervening years of ultra-loose monetary policy, EM stock prices are barely higher now than they were at the end of 2009!1

Given that loose Fed policy doesn't appear to have helped EM stocks much, it's questionable how much Fed tightening will hurt them.

But, there was an increase in lending to EM countries for a while there, and it's possible that tighter Fed policy could lead to liquidity issues in emerging markets. This is a short-term consideration, however: while liquidity problems could temporarily increase volatility or reduce valuations, they are unlikely to significantly alter the long-term fundamentals of EM stocks.
 
United States Stock Market
Background
 
Share of global economic activity 22% 2
Share of global stock market capitalization 39% 3

Long-Term Prospects

In contrast to international markets, the US stock market has famously seen substantial gains for the past few years. But this seems to have been due more to rising expensiveness than to a sustainable increase in fundamentals. Reliable measures of valuation have risen to the point where most of them are higher than they have been at any time outside the dot-com bubble.9 Additionally, US stocks recently traded at the highest premium to international stocks for at least 35 years.10

There is one segment of the US market that appears to be priced more reasonably than the rest, but for the US market overall, long-term prospects appear unusually poor. Unless "this time is different" (and below we'll explain why it very likely isn't), US stock investors have a good chance of ending up disappointed, or worse, in the years to come.

Popular View

True to the tendency for extrapolation, now that investors can look back to several years of really good gains, the popular narratives about US stocks have become quite optimistic. And yet, most of them are either myopically focused on the short term, or are based on those four most expensive words in investing: "this time is different."
 
Popular Viewpoint Our Thoughts
The US economy has been growing faster than other developed world economies True — but not really that important for long-term stock returns. Economies have ups and downs, and being in an "up" part of the cycle right now doesn't automatically make something a good long-term investment.

In fact, the opposite is more likely to be true. Recent economic outperformance has tended to be associated with stock underperformance in the ensuing years.7 This is probably because stocks tend to become overpriced when things have recently gone well, as appears to be happening in the US.

It is true that the US has an unusually dynamic economy, which has historically led to faster growth and slightly higher stock valuations than in many foreign countries. But that premium has typically been fairly small, bearing no resemblance to the huge valuation gap we see today. Based on fair value estimates, the US is priced 43% above its historically typical premium to international stocks.11
US profit margins will remain high This one requires a bit of background, but it's crucial to the argument about whether US stocks are overvalued.

"Profits" refer to how much companies earn after all their expenses, and "profit margins" refer to the ratio of profits to sales.

Profit margins have historically been highly mean-reverting.12 We explained why in the last article: advantages and challenges are relentlessly competed away between companies, high profits draw more competition, and so on.

Right now, profit margins are far above their normal levels.12 If they were to revert to normal, this would be a major drag on future earnings growth. So the current level of earnings is giving a very over-optimistic view of that all-important future earnings stream, if margins are going to return to normal. There are very good reasons to believe that they are.

The first is that margins have historically been highly mean-reverting, due not to chance, but to fundamental characteristics of the economy. These characteristics have not changed, so it's reasonable to believe that they will push profit margins towards more normal levels as they always have.

Second, the specific factors that have contributed most to the recent surge in margins are not likely to continue indefinitely.
  • Wage costs are a big part of corporate expenditures, and the recent weakness in wages has played a major part in boosting margins. The problem, as far as it concerns corporate profits, is this: consumer spending accounts for nearly 70% of economic activity in the US.13 It should be clear that corporate revenues, and thus profits, can only grow so much without US consumers participating in that growth. (As it happens, there are early signs of a pickup in wage growth, so this factor may start to eat away at margins soon).
  • Corporate borrowing costs have plunged as rates have approached all-time lows.14 This has directly boosted the bottom line, but it cannot continue unless rates remain at these levels. Even if rates stay where they are, low borrowing costs are shared among companies and should get competed away over time.

Technological advances are often cited as a reason for margins to remain at a permanent high, but this argument has been made over and over in the past, and has never turned out to be right. Technology has continually improved, but because of the competitive nature of our economy, the benefits have eventually accrued to consumers, not to corporations. While we are excited about the increased productivity and prosperity that should result from many of today's new technologies, we don't believe that new technology will permanently increase profit margins any more than it did in the past.

As unlikely as it seems, we do have to be open to the possibility that there is some factor pushing up margins on a permanent basis. But even if this were the case — which is, again, very unlikely — there's no reason to expect this factor to apply only to the US economy. And yet, US stocks are the only major area to be priced as if record-breaking profit margins are a permanent condition.
Low rates make stocks worth more The idea that low interest rates justify higher stock valuations has been around for a long time, and even has its own name — the "Fed Model." Unfortunately, while the Fed Model can be useful in assessing short-term risks, its usefulness for long-term investors has been thoroughly and repeatedly debunked.

Here, in brief, is why: it's true that people have historically paid more for stocks when rates were low, but it's not true that this worked out well for them in the end. It turns out that their eventual returns were just as poor as they would have been if they'd overpaid to the same degree when rates weren't low. This is because valuations predict returns independent of interest rates.15

Low rates may explain why investors are overpaying for stocks, but that doesn't make it a good idea to join them.

If we knew for sure that rates would stay low indefinitely, that might justify higher valuations. (Though not as much as people tend to think… indefinite low rates would be associated with lower rates of growth, thus reducing stocks' future return potential.) Regardless, we don't know that low rates are here to stay — far from it — and people who invest on that assumption are making a big "this time is different" bet. Even if it turns out to be right, rates will probably be low globally, so this still doesn't justify buying expensive US stocks when there are much more reasonably priced markets around the world.
"QE" is an unprecedented factor that renders old valuation measures meaningless "Quantitative easing" (in which the Fed creates new money to buy bonds) certainly seems to have helped raise stock valuations, but there is no reason it should permanently alter stock fundamentals or the future stream of long-term earnings. So whatever effect QE has should be reversed as the program is eventually unwound. (The Fed ended its QE operations in 2014, but we wanted to include this one as it's an argument we've heard many times).
The "shale revolution" is good for the US economy Increased US energy production is certainly good for the US economy, but the energy industry only accounts for about 2% of US economic activity.16 The shale boom does not come close to explaining why US stocks trade at a 68% premium to their historical values.11

Lower energy prices are also a positive for the US economy (though they are a negative for the energy industry). But this is also a relatively small effect compared to the level of overvaluation in the market. Moreover, this is an advantage that is shared across the economy, and across the world, and shouldn't be expected to permanently boost margins any more than any other shared advantage.
Most of these arguments only apply to the US, for some reason Many of the factors cited above, which are commonly used to justify US stock valuations, apply to international stocks as well. All around the world, rates are low, central banks are engaging in unprecedented easing, and energy prices have plummeted. If some productivity miracle or some other unseen factor is going to prevent profits and margins from mean-reverting as they always have, there's no reason to expect this to be confined to the United States.

Yet these arguments are typically used only in favor of the market that's gone up the most for 3 years, even though, if they were valid, they would apply to other markets too. This suggests that they aren't really sound arguments, but rationalizations and excuses to extrapolate the recent past into the indefinite future.
 
Expected Returns and Current Positioning
If we can assume that the things that have reliably mean-reverted in the past (for good reason) will generally continue to do so, then we can make a reasonable estimate of the long-term returns for different areas of the markets. A highly-regarded investment research and money management firm called Research Affiliates has done exactly that, and their estimates are shown below.
 

Research Affiliates' model assumes normal trend earnings growth and a partial mean-reversion in valuation, so most of the variation in potential returns comes from current expensiveness. Thus, the very overvalued US market is priced for poor returns, the reasonably-priced developed markets for pretty good returns, and the slightly cheap emerging markets for very good returns.

In addition to these high-level categories, we assess sub-categories and often find opportunities there. For instance, the subset of the US stock market known as "quality stocks" is priced quite a bit more reasonably than the US market as a whole17 (still on the expensive side, but more attractive than the overall market). For both developed and emerging international, "value stocks" are priced for significantly better returns than the top-level categories.18 (We also do similar analysis on non-stock investments, but we are confining this article to stocks).

Our stock positioning is based on these prospective returns, and currently can be summarized like this:
 
Concluding Thoughts
These two articles had a number of goals: to provide a framework for how we view stock investment; to encourage focusing on factors most important to long-term returns and tuning out the "noise"; to address the important factors (and the noise) for the big 3 areas of the global stock markets; and to explain our current investment stance in light of all of the above.

We hope this has provided a stronger understanding not just of why we are invested the way we are, but why we feel so confident that this is a sound and prudent approach for long-term investors.


Sources:
1 Yahoo! Finance
2IMF
3Credit Suisse
4Morningstar (based on holdings of these exchange-traded funds: EFA for developed international; EEM for emerging international)
5Research Affiliates (based on Cyclically-Adjusted P/E ratio; see the footnote in our prior article for background)
6 Markit Economics
7 GMO
8 IMF
9 Doug Short
10 Meb Faber Research
11 Our own calculations based on return forecasts from Research Affiliates
12Office of Financial Research
13St. Louis Federal Reserve
14St. Louis Federal Reserve
15"Fight the Fed Model," Clifford Assness
16Bureau of Economic Analysis
17GMO
18 GMO Asset Class Forecasts (full version; not online)