Valuation of US stock market
In our previous article entitled Is The S&P 500 Severely Overvalued? Look From 5 Different Angles, we looked at the valuation of the US market from five different valuation indicators – Price to Earnings Ratio, Price to Sales Ratio, Price to Cash Flow Ratio, Price to Book Ratio and Dividend Yield.
The different indicators gave us different signals from fairly valued to over-valued. Therefore, there is a need to use our Composite Valuation Indicator, which finds the best combination of the five indicators, to give us one conclusion about the market. And the conclusion we drew one month ago was that while the US stock market is over-valued, it is not in bubble territory.
Information about a stock market’s average historical valuation and its current valuation, plus estimates of where market fundamentals (i.e. earnings, sales, book value, cash flow and dividends) are heading will give us an idea of the direction of the market.
This, however, may not be enough for professional fund managers. With mandates to invest in multiple countries, fund managers often have to choose what portion of the portfolio to invest in which countries. And it is not enough to determine the direction of each market. There is also a need to determine whether one market will do better or poorer than other markets.
This is the issue that this article will address. What information must we have to determine if a market will outperform another market and what does current data tell us about the likely performance of the US market vs. the world going forward?
US Investors are predominantly home-centric
Unless forced to invest overseas by a regional mandate, most investors would rather just invest in the home market. In a CNBC article, it was reported that US investors only have, on average, 15% of their investments outside the US. This is no surprise as US equities have outperformed world equities since the country came out of the global financial crisis in 2008.
The preference to invest mainly in the home country stems from the desire to keep things simple. Going outside of home for many people is stepping out of the comfort zone. According to the article above, even Warren Buffett admits that concentration of investment in the US is more for those who want to keep things simple than for those that want to achieve the highest return for the lowest risk.
With much talk about the US market being over-valued, many investors are starting to wonder if better returns could be found outside of the US. The big question is: after outperforming world equities for eight years, will the US market continue to do so? Outperformance of US equities vs. world equities is not a given. Even though it has done so for the last eight years, the preceding eight years saw the US market underperforming by an even greater measure. And indeed, the US market has already started underperforming world equities in the last one year.
The reasons why markets outperform
There are only two reasons why one market outperforms another. This stems from the basic understanding that a stock’s price is its valuation metric multiplied by its underlying value. So, this could be:
· Price Earnings Ratio x Earnings per Share
· Price to Sales Ratio x Revenue per Share
· Price to Cash Flow Ratio x Cash Flow per Share
· Price to Book Ratio x Book Value per Share
If we take the first case – Price Earnings Ratio x Earnings per Share – there would only be two reasons why Market A outperforms Market B.
One, when PE Ratio of Market A divided by PE Ratio of Market B goes up. For example, Market A used to trade at the same PE as Market B. However, in the last few years, it has moved to trading at a premium. This movement from parity to premium would cause Market A to outperform Market B even though the earnings growth of both markets are identical.
Two, earnings growth of Market A is higher than earnings growth of Market B. If this is true, then even if the PE relationship of the two markets remain the same, Market A will outperform Market B.
The above reasoning would be true for the other market indicators. E.g. when Price to Book Ratio of Market A vs. Market B improves. Or when book value of Market A grows faster than book value of Market B.
The basis of this study
In order to determine whether the US market will outperform world markets, we had to gather two categories of information.
The first is valuation metrics. We looked at Price to Earnings Ratio, Price to Sales Ratio, Price to Cash Flow Ratio and Price to Book Ratio of the US market and compare this to the world market starting from 1996. This 20+ years cover many of the market extremes including the Asian Economic Crisis, Dot-com Bubble, Global Financial Crisis, etc. and is therefore a good enough period to draw conclusions.
For each of the four indicators, we determined what is the normal relationship (e.g. US market usually trades at 20% PE premium to world markets) and look at where it is standing now.
The second piece of information we gathered are the fundamental projections. For example, how fast are earnings in the US expected to grow in the next three years compared to earnings in world markets? In order to gather information on world markets, we compiled information from 42 stock markets, which together account for 97% of the world’s market capitalization. The companies we gathered information from are component stocks of the major indices in the respective countries and together they number slightly more than 10,000 companies.
The empirical data proves that what we already know from finance theory is true. The relative growth rate of earnings, sales, book value and cash flow did a good job of explaining the relative performance of the two markets. The changing of relative valuation played a part too, especially when valuation recovers from depressed levels seen during the global financial crisis.
The first chart below shows that the US market trades at an average PE premium of 18% compared to world markets (see the red line). The thing that caused US market to outperform or underperform is the rate of earnings growth in the US compared with the rest of the world. Going forward, the chart shows that earnings growth in the US will be roughly the same as world earnings growth. Earnings growth for the US is compiled bottom up from S&P 500 companies, whenever estimates are available, and earnings growth for the world is compiled from slightly more than 10,000 companies in 42 countries.
The second chart below shows the US market trading between 18% Price to Sales premium (during the global financial crisis) and around 75% premium just prior to the bursting of the dot-com bubble. Currently, it is trading slightly above the average premium of 47%. Sales in the US is expected to be flat compared with world sales growth.
The third chart below shows the US market trading at a high Price to Book premium of around 60% compared to the world and book value in the US is expected to grow at the same rate as world book value.
The fourth chart below also shows the US market trading at the historical high Price to Cash Flow premium of around 50% but Cash Flow for US companies are expected to grow faster than the world.
While the four charts show a slightly different picture, the Price to Earnings chart has the best predictive power and based on that chart, we could expect the US market to perform flat vs. world equities in the next few years.