Turn on the financial news networks; CNBC, Bloomberg News etc. and it is easy to get swept up in the myopic reporting and observations of newscasters and commentators. The actors in this financial saga that make me laugh the most are the ones that speak with absolute certainty about what the markets will do next. The simple fact of the matter is no one knows what the markets will do from one day to the next and anyone who tells you different is just another snake oil salesman. For this reason, I believe investments like the stock market are not for the short sighted investors who get caught up in the hype (like the pic shown). Most astute investors know that the consistent money in the stock market over time is made by keeping a long term view and not losing your cool when a (smart) investment moves against you.
Simple, boring techniques like consistent saving, dollar cost averaging and investing in broad indices through ETFs and index funds are the way to go to get a consistent long term annual return.
However, there are broader trends over time that the media and most observers ignore on a day to day basis and may affect the way that you want to allocate your portfolio. Although it has become a bit more fashionable recently to observe long term ratios, it is worth looking at some of the long term valuation factors and market conditions that may give one pause when considering jumping into the stock market or the bond market currently.
The Long Haul
I always have taken a long term view of the markets. I look for a consistent return over time as opposed to one off trades that are difficult to replicate year over year (and not to mention are taxed differently than long term investments). As I have been stressing for many months now, the US stock market seems to have very lofty valuations at the moment. One measurement that I like to look at to determine if the stock market is overvalued on a historical basis is the cyclically adjusted price-to-earnings ratio, commonly known as CAPE, Shiller P/E, or the P/E 10 ratio. This is the price of the broad stock market index (say the S&P 500) divided by average of 10 years earnings of the entire market, adjusted for inflation.
Robert Shiller, a professor at Yale, probably most famous for creating a US housing price index, offers his excel plot of historical stock market data for free here, below you can see a plot of the CAPE ratio over the entire history of the S&P 500.
This is a ratio used by the likes of investors like Warren Buffet who look towards the valuation of a company or of a market over a long period of time. It is also a figure that can give one a lot of confidence to make big investments when the ratio dips severely and suddenly as it did during the financial crisis. If you were keeping up with it, that was the time when Warren Buffet made a lot of his largest investments of the past 10 years.
Of course commentators will continue to speculate on how the market may not be overpriced and there is no definite ceiling to the valuation. I for one make the argument that over time there have been structural shifts in the way the world saves and invests that have pushed up the overall pricing of the S&P 500 over time. The current CAPE figure sits at 29.19 versus an all-time average of 16.75 which would imply that the market is very overvalued, but as you can see below, if we break the time period we measure down into some segments, it is clear that the average CAPE ratio of the market has been gradually increasing over time.
There could be a number of reasons for this shift. We have to remember that people’s retirement is in their own hands through 401k type plans now as opposed to in the 60’s and 70’s when many people paid into a pension managed by a professional which may have been more tilted towards bond investments. The workforce in the US is also larger than in the past and the S&P 500 is limited to only 500 companies since its founding, which means you have more money chasing the same amount of companies, pushing up the pricing. Or that since 1990 there has been the fall of communism in much of the world in addition to the liberalization of financial markets and investment products. If you are in a country that doesn’t restrict you to capital controls you are free to invest pretty much where ever you like, and the US stock market has been a consistent winner. Be it the transparency, size, or rule of law that the US offers, investors around the world have continued to flock to the US market to take advantage of the long term stock market returns.
Taking a Look Elsewhere
In that sense, based on the average CAPE of the past 27 years, the current valuation doesn’t seem so high but what about other markets? Maybe the largest market in the world, the US dollar bond market may be attractive right? Estimated in 2013 to be $39.9 trillion this market is more than twice the size of the US stock market. However interest rates are increasing and expected to be increasing for some time. This doesn’t bode well for the purchase of long term bonds which will drop in value as rates rise. Shorter term bonds will offer smaller returns that won’t compare favorably to the stock market on a long term basis.
Another option will be to look internationally; there are ETFs that offer diversification through global indices or through foreign stock markets. One has to be careful though when using a global index like the MSCI World Index for diversification purposes. The US stock market, due to its recent run and its size dominates almost all global indices based on market capitalization. Take a look at the most recent composition of the MSCI below to get an idea of how much the US market dominates the global one.
The US not only dominates in terms of size, all of the top 10 holdings are US companies. So a world index doesn’t necessarily offer you a wealth of diversification on an international basis. If you are interested in moving in this direction though, ETFs like the Vanguard Total World Stock ETF (Symbol: VT) can capture this index.
I think this is where most people that don’t have knowledge of international markets stop, other stock markets are so small and volatile in comparison to the US market and everyone is piling into the US market anyway, so why not just follow the crowd? That is the flawed thinking that can stray one away from awesome returns that can potentially be had internationally.
Back to the CAPE
In order to start to evaluate others markets we can apply the CAPE to other national markets and see what type of valuations we get. Luckily it didn’t take me long to find a hedge fund named Star Capital that has already complied the data based on the most recent quarterly results.
By ranking them by their CAPE ratio 2 countries really jump out at me. The first is Russia, no matter what you think of the current political climate or the cronyism in Russia it is hard to ignore a CAPE ratio of 5.3 and a P/E of 7.1. The political climate, government meddling and high exposure to oil & gas are of course valid concerns. However we are talking about large companies in a nuclear armed and relatively peaceful country. Sberbank, Gazprom and Magnit (the largest retailer in Russia) aren’t going anywhere anytime soon. Depending on how things play out in Russia, we could be looking back on this a decade or 2 from now and asking why didn’t we allocate just a bit of our risky bet portion of the portfolio to Russia based on these valuations?
The other country that stands out to me is Brazil. I feel there is even more of a case for investing in Brazil right now and will dedicate a future post for the reasons why. Although Brazil has been in the news lately because of turmoil in the government due to the lava jato (car wash) scandal that has embroiled many top politicians and removed the president from office, I see this as a long term developing maturity of the political class in a representative democracy, with a young population and sophisticated (although still relatively small) middle class. Although the country is still recovering from the worst post war recession in its history, the Bovespa (local index) has turned the corner and returned 50% in 2016. Based on the current CAPE valuation and the bounce back in the economy, it is pretty likely that spectacular returns may be seen in the near future.
Conclusion
It seems pretty tough to lock in a good long term return in the US market based on its current valuation. That is not to say we should all sell all our holdings and jump into cash but a measured diversification internationally into reasonably priced markets may be an attractive option for those looking to devote a part of their portfolio away from the dearly priced US market.
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