By Jeffrey Kleintop, Charles Schwab & Co.
Although world stock market valuations are above average, similar valuations have produced double-digit gains over the following 12 months during the past 50 years.
Relative valuations do not currently favor one country or region’s stock market over another.
Valuations support a globally diversified portfolio offering the best diversification benefits in 20 years.
Stocks are up every month this year supported by the broadest economic growth in a decade. This is great news. But, have stocks already priced in all that good news? Is it too late to buy? Are stocks expensive?
Are stocks expensive? Maybe too expensive to buy?
History says no. While valuation is important to long-term returns, there has been no consistent relationship between the price-to-earnings (PE) ratio (the price per share divided by the last 12 months of earnings per share) and stock market return over the next year.
The current MSCI World Index PE ratio is 21.3. Since the inception of the MSCI World Index in 1969, a PE in the range of +/- 0.5 around 21.3 (20.8 to 21.8) has been followed by a total return of -5% to +45%, with an average return of +17.5%. Though valuations are above average — reflecting the better than average economic and earnings environment, there is no reason to believe stocks couldn’t go higher over the next year and even produce double-digit gains based on nearly 50 years of history, although of course history is no guarantee of future performance.
Are some markets expensive?
The global stock market may not be too expensive to rise, but what about the markets of different countries or regions — are some too expensive relative to others?
The U.S. has one of the highest PE ratios among countries or regions right now. Compared with the MSCI Euro Index, which tracks stocks in the 19 Eurozone countries, with a PE of 18, the U.S. looks pricey. Japan, at a PE of 15, looks like a real bargain.
Should investors favor Japan over the U.S. and Europe because it has a lower PE? We believe the answer is no, as all three of these markets are fairly valued relative to how they perform. We can see this when looking at the sectors that drive the performance of these markets.
The U.S. tends to behave like the global tech sector. So it isn’t surprising that the MSCI USA Index is valued like the MSCI World Information Technology Index, with a similar PE of 25. Strictly speaking, the U.S. stock market is composed of only about 20% tech stocks. So, in theory, the incredibly tight correlation of 0.99 between those two shouldn’t exist. But, in reality, it does. A bottom up weighting of the PEs of the stocks that make up the U.S. index misses the point of how the U.S. stock market actually behaves, and therefore, is valued.
The Eurozone is composed of 19 European countries and tends to perform like — and is valued just like — a combination of three different world sectors: financials, telecommunications, and materials. The MSCI Euro Index behaves like a mixture of .41x MSCI World Financials Index; .34x MSCI World Materials Index and .33x MSCI World Telecommunications Index. The weighted PE of those global sectors is 18, the same as the Euro index.
Let’s now look at Japan. The consumer discretionary sector is the largest sector of Japan’s stock market, which includes globally-recognized companies like Toyota and Sony. But the influence of financial conditions on all types of Japanese companies is evident in their performance which tracks the financial sector closely. Japan’s stock market is valued similarly to the MSCI World Financial Index at a PE of 15.
The takeaway from this comparison of countries and sectors is that the valuation differences between countries reflect how they perform and gives a very different investment conclusion from a simple comparison of the country PEs. Currently, these countries or regions do not appear materially over or undervalued relative to the sectors that they track. The sector PEs are all above average, but they are similarly valued relative to their 15-year histories. Each sector PE falls between 65% and 78% of that sector’s 15 year high.
All this suggests relative valuations do not currently favor one country or region’s stock market over another when seeking value. We favor asset allocations across borders in line with their strategic weightings in U.S. and international stock markets which mirror the weights in the broad indexes.
Diversification offers best value in 20 years
With stock markets valued fairly relative to how they perform there is little reason not to be globally diversified. From a diversification perspective, there hasn’t been a better time in 20 years to be globally diversified. The trend in correlation among countries has fallen to the lowest levels since the mid-1990s. Many investors have never seen this low correlation before in their investing lifetimes.
It’s not too late to buy. Valuations support a globally diversified portfolio offering the best diversification benefits in 20 years.
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