The financial industry has a short memory, so whatever has outperformed recently is often expected to keep outperforming over the long term.
It’s uncomfortable to start buying into an asset class that has been out of favor, and career risk is one of the biggest inefficiencies in the market. People managing a lot of money don’t get too much heat when their assets are down while everyone else is down too, but they do get a lot of heat when they’re down while their peers are up. Nobody can afford to be wrong alone, so it’s safer to follow what everyone else does.
There is so much media attention on U.S. markets, and trillions of dollars are put to work here, bidding up valuations. Interest rates remain low, which keeps the equity risk premium high even at relatively low earnings yields and low-ish expected forward returns.
The ratio of market capitalization to GDP in the United States is historically high. Currently it’s at 139%, with the height of the dotcom bubble at about 149% being the highest level for the ratio on record.
The following chart courtesy of the St. Louis Federal Reserve shows the relationship between the total stock market capitalization (blue line) and GDP (red line) over the past three decades:
The main criticism that people levy at this ratio is that, in theory, if U.S. companies get a lot more of their revenue from abroad over time, then their combined valuations could justifiably grow faster than U.S. GDP.
While this is true if it were to occur, it hasn’t been occurring for some time. Companies in the S&P 500, which make up the bulk of the U.S. stock market capitalization, received 43.62% of their revenue from outside of the United States in 2017 compared to 45.84% ten years prior in 2007 according to S&P Dow Jones Indices. This figure has been consistently in the mid-40’s year after year over the past decade, and not much different during the decade before that.
So when you see that the value of the stock market equaled 100% of GDP in 2013 compared to 139% today, it is mostly attributable to higher profit margins and valuations. Tax cuts and a stronger economy have pushed margins up to about 12% today compared to 10% in 2013. And then a rich (but not excessive) multiple on those high margins puts U.S. stocks at rather lofty levels based on most metrics. Investors are expecting a lot from U.S. stocks at this point, and yet margins tend to be cyclical- highest in the mid/late portion of the economic cycle and lowest during recessions.
There are three main drivers of stock market returns over any lengthy period of time: dividends, earnings growth, and changes in valuation. Dividend yields are straightforward, earnings growth is more challenging to predict, and changes in valuation between now and several years in the future are the wildcard that could vary significantly. Going international gives us more rocks to look under for good returns, but also adds a fourth variable: currency fluctuations.
Research Affiliates, a large research firm that provides financial institutions with asset allocation data, currently expects U.S. stocks to give the worst equity returns over the next decade compared to other geographies:
Specifically, with a 2.1% dividend yield, 3.4% average growth per year, and a -2.6% average valuation reduction per year, they expect about 2.9% total annual returns for large U.S. stocks over the next decade. Even if you factor out the anticipated valuation reduction, which is a more bullish case, it brings the expected returns to a still-unexciting 5.5% per year.
In contrast, the firm expects developed foreign markets (EAFE) to give 7.8% returns per year over the next decade from a combination of a 3.7% dividend yield, 3.8% growth, and a basically flat valuation increase of 0.2% per year. This is where I likely diverge from their conclusions; I have skepticism that EAFE countries will achieve that growth in the coming years and I suspect the potential for a value trap in these geographies.
Lastly, emerging markets score the highest with their methodology. With a 3.1% dividend yield, 5.0% growth, and a modest 1.2% annual valuation change, total EM annual returns are estimated to be 9.3% over the next decade. Even factoring out the expected positive valuation change leaves the returns at a respectable 8.1%, albeit with high volatility.
Diving down into individual countries can perhaps give us better returns, and that’s something I research regularly. Value can be found in all sorts of places, especially if you’re willing to risk looking silly in the short term to profit over the long term as fundamentals play themselves out over a business cycle.
Sometimes a country is so beaten down, with such low expectations and valuations along with high yields, that even a modicum of stabilization can provide investors with great returns (think Russia or Turkey). Other times, a fast-growing country might be highly-valued at first glance, but a growth-at-a-reasonable-price strategy can give patient investors good entry points into such a desired market (think India or Indonesia).
Even in the United States, however, I do believe there are pockets of value. Some companies can propel their share prices upward as their successful business plans unfold even as the rest of the market struggles. More simply, there are some sectors that are out of favor, and high-quality companies in those sectors may be able to provide a good balance of returns with decent yields, solid growth, and attractive valuations.
The Great Divergence
U.S. stocks have crushed the rest of the world during this decade:
Part of this divergence was due to fundamentals, but EAFE and EM also saw significantly reduced valuations during this time period while valuations within the U.S. market inflated.
In the decade before that, from 2000 to 2010, quite the opposite happened:
During that decade, U.S. stocks lagged as fundamentals were volatile and valuations deflated from the dotcom highs. Emerging markets soared during this time, driven by strong fundamentals and a shift from low valuations to high valuations.
Looking at the numbers today, it looks more like the start to the 2000s than the 2010’s. Emerging markets as a group are beaten down with the lowest valuations compared to U.S. valuations in well over a decade. While pockets of bad USD-denominated debt do exist in certain emerging markets, and China’s well-known corporate leverage problem is ripening, most emerging countries have lower overall debt levels than developed countries, higher real interest rates, more favorable demographics, and faster real GDP growth.
There are a lot of reasons to be concerned about global growth at this perilous time, but it’s exactly that broad concern that may provide lucrative opportunities in the coming years for those that are willing to think ahead and that are not overly concerned with high volatility and uncertainty for a portion of their portfolio.