August 8, 2017

In the last market update, we shared some economic indicators that showed an upturn in the global economy, with Europe in particular growing more strongly than it has in many years. Global growth has continued looking good since then, and world stock markets have responded with further gains.

The positive economic and market backdrop has gotten investors pretty optimistic, but it wasn't long ago that fear of a potential President Trump had market pundits and the press predicting imminent disaster for stocks if Trump were to be elected. For example, we recently came across this list of headlines from around the time of the election:
 
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Source: InvesTech Research

Although nobody knows what is next for the markets, we know that anyone who got out of the markets because of the election has been left pretty far behind. And we also know that there will be a bear market at some point for one reason or another. What's important to internalize is that there obviously wasn't an easily predictable cause and effect relationship between the markets and the election results. It's hard to treat such reports as those listed above as noise, but it's important to do just that. This is worth keeping in mind as you read today's hyped-up market news stories, be they positive or negative.

Valuation Thin Air

We've been leery of US stocks, but it's got nothing to do with politics. We discussed why in the last article: they just aren't priced for very good long-term returns, especially when compared to much less expensive markets outside the US.

Here's another way of looking at it, from AMP Capital:
 
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Source: Global Financial Data, AMP Capital

This chart shows valuations (price divided by 10 year average earnings) for various stock market groups going back to 1980. It really drives home the extent to which market valuations have tended very strongly to cluster together. Whenever a market has historically gotten away from the pack valuation-wise, that divergence hasn't been sustained —despite very persuasive and widely-believed stories at the time that had people convinced those prices were justified.

Also notable is the unusually large valuation gap between the US and the rest of the world today. The chart shows only two prior instances in which one market has strayed so far from the rest: the "World excluding the US" in the late 80s (driven largely by an immense bubble in Japanese stocks), and China right before the financial crisis. Those both ended very badly for the outliers, as the steep eventual declines in valuation make clear.

There's also just one instance in which US stocks got more expensive than they are right now: the dot-com bubble, which peaked in 2000. There was less divergence there because stock markets worldwide all got really expensive—but as a result, they all declined steeply when the bubble burst.

Fortunately, the US is significantly less expensive than the outliers in those prior episodes, and international stock values currently look quite reasonable compared to history. But there's an awful lot of valuation "thin air" between the US and the rest of the world right now.

People have come up with all sorts of rationalizations for why this will continue forever. But, again, they did that in those prior episodes too. In the end, valuations always synced back up and moved back towards normal. (And with good reason—it just doesn't make sense for one country or region to be dramatically more expensive than the rest of the world for any great length of time).

It's a pretty good one-picture overview of why we think a globally diversified, value-aware investment approach could be a major advantage in the years to come.