May 23, 2014

Our prior article presented evidence that valuations have had a huge impact on returns and risk when investing in the US stock market. This article will discuss some data showing that the same is true for global stock markets.

In his excellent book Global Value, market analyst and money manager Mebane Faber describes a simple approach to testing the importance of valuations for global investors. In short, Faber measured what would have happened if an investor had simply invested in the stock markets of the cheapest 25% of countries and then rebalanced annually.1

The green line in the following chart shows how this strategy would have done over the past thirty-plus years; the black line shows what would have happened if one had just taken the "passive" approach of buying and holding the stock markets of all countries.

Cheap markets return more than buy and
hold, which returns more than expensive markets.

The strategy of buying the countries with the lowest valuations performed far better than the "buy and hold everything" approach. Both of these approaches, in turn, performed far better than buying the most expensive countries, the result of which is shown by the red line.

All in all, it's crystal clear that valuation matters tremendously to long term investing outcomes. Buying what's cheap or reasonable and avoiding what's expensive, if done in a diversified and disciplined manner, has historically led to much better returns in the long run.

Valuations can take a long time to do their work, though. The "buy the cheap countries" strategy shown by the green line often underperformed the buy and hold approach -- sometimes by a wide margin, and sometimes for several years at a time. But the dramatically better long-term results show that taking the value-oriented approach has paid off handsomely for those who stuck with it. There's no reason at all to believe this has changed.

Current Market Situation

From a valuation standpoint, markets are currently a mixed bag. Some markets are reasonably priced, but some have reached dangerous levels of overvaluation. This can be seen in this graph of the most economically important countries' stock market valuations:

Country valuations

Clearly there are some pretty big differences, and those differences generally translate to a big gap in the future returns that investors can expect.

The next graph gives an idea of how different those returns could be. It shows return forecasts that are based on the assumption that valuations and profit margins will return once again towards historically normal levels, which they have had a very strong tendency to do over time. Assuming that this happens over seven years, and that inflation averages 2.5% over that period, here are the returns we might expect for various asset classes:

Return forecasts

The difference in prospective returns is dramatic. As its sky-high valuation would suggest, the overall US stock market is priced for truly dreadful (and negative, after inflation) returns, if valuations revert to normal. US small caps are even worse.  Things look a lot better overseas, however, and there are pockets of global markets that are actually priced to deliver pretty good returns. (For our own portfolios, we are maintaining modest exposure to these areas, while keeping a healthy amount of "dry powder" in the expectation that we will get an opportunity to invest at better valuations in the future).

Valuations haven't mattered much over the past couple years, but these value-ignoring episodes are typical of the cycles of the market. They've always ended before, and we expect that this one will as well. It's possible that it's even starting to happen already, as some of the cheaper areas of the markets have been outperforming over recent months. But regardless of whether this trend continues in the immediate future, we expect that in the end, having paid careful attention to value will make a very big -- and positive -- difference.

1 - Each country's stock market valuation was determined using the Cyclically Adjusted Price-to-Earnings ratio (a very reliable valuation metric, discussed in the recent article linked above). Once per year, the portfolio would be invested equally into the stock markets of the 25% of countries with the lowest valuation at the time.