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Consider Investing in Global Stocks, Which Appear Cheap

Why International Diversification Matters Today (Part 4 of 6)

(Continued from Part 3)

Relative valuations.

A willingness to pay up for U.S. equities has resulted in several years of steady multiple expansion. While the current premium on U.S. stocks makes some sense in the context of low inflation and low rates, valuations look stretched relative to stocks in the rest of the world. This is particularly true based on the price-to-book (P/B) measure. Currently the P/B on the S&P 500 Index is roughly 75% higher than for the MSCI ACWI-ex U.S. Index. This is the highest premium since the market bottom in 2003. Longer-term metrics, such as cyclically adjusted price-to-earnings, or CAPE, ratios, are even more troubling, suggesting that U.S. stocks are likely to produce, at best, average to below-average returns over the next five years. The U.S. may have the best fundamentals, but U.S. equities have rarely posted stellar returns from today’s valuation levels, as I note in my Market Perspectives paper.

Market Realist –

Consider investing in global stocks.

The graph above compares the price-to-book (or PB) ratio for the S&P 500 (VOO) with the MSCI ACWI Ex US Index (ACWX), which tracks global stocks.

Currently, the S&P 500 (IVV) is trading at 2.93x book value, whereas ACWX is trading at 1.75x book value. The long-term averages of the PB ratio are 3.0x and 1.88x, respectively.

Historically, the S&P 500 has traded at a premium of 59.3% over the ACWX. Currently, though, the premium appears quite stretched at 67.7%.

American stocks (VTI) are facing several headwinds, as discussed in part 2. Such a premium is not justified, especially given the strength in developed market equities (EFA), as discussed in the previous part.

The second graph shows the CAPE (cyclically adjusted price-to-earnings) ratio, which uses real per-share earnings over a ten-year period. It uses smoothed real earnings to eliminate the fluctuations in earnings caused over a typical business cycle.

Currently, the CAPE ratio for the S&P 500 stands at 27.1x earnings, which is the highest since pre-crisis. The returns on the index are likely to be muted for 2015 and more, until earnings catch up with the index.

Continue to Part 5

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