August 8, 2017

We discussed why we're leery of US stocks 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.