U.S. Investors Need to Shed Their Home-Country Bias
(Bloomberg View) -- Investors have been told for a few years that all financial assets are expensive. This conclusion has led market participants from retirees to pension plans to worry about future returns given that government bond yields are at sub-3-percent levels and stock market valuations are close to the highest levels in history.
But these investors may be looking in the wrong place.
Since just before the global financial crisis began in late 2007, corporate bond yields have dropped from 5.3 percent to 3.1 percent. High-yield bonds have gone from 8.5 percent in October of 2007 to 5.7 percent now; they reached 22 percent during the financial crisis. Yields on real estate have fallen as well. REITs have seen dividend yields go from double digits in early 2009 to just over 4 percent today. Even private equity multiples are getting stretched as the multiples firms are paying for private companies are now in the double digits.
There is a theme running through these examples. Each of these assets is based in the U.S. To find cheaper assets, investors are going to have to go abroad into foreign markets, but many U.S. investors have a home-country bias. If we look at the stock markets around the globe, things aren’t quite as stretched in terms of valuations. This table looks at the different regions of the global equity markets by a number of different valuation metrics:
The U.S. makes up about 50 percent of global stock market capitalization, so this gives you an idea about how much of an outsized impact the U.S. is having on world and developed-market valuations. Emerging markets are the obvious outlier here, with much lower valuations across the board. The valuation differences are much more pronounced and visible when breaking things out by country:
The U.S. has the most diversified and dynamic economies of any country on this list, so it’s never quite an apples-to-apples comparison. There are differences in sector composition, concentration among top holdings, and structural changes over time in the makeup of the companies in these markets. Plus, globalization has blurred the lines when it comes to multinational firms and where their revenue originates. But foreign markets, by and large, offer investors higher yields in terms of dividends, earnings, cash flows, book value and sales. Over the long term, these higher yields and lower valuations should give the rest of the world higher expected returns from current levels.
And even if there isn’t such a stark contrast in the valuations, the simple concept of mean reversion has to kick in eventually based on the performance of the various markets. The 10-year trailing returns in U.S., European, Asia-Pacific, and emerging market stocks shows just how dominant the U.S. has been over the past decade:
This type of relative outperformance can’t last forever, or the U.S. would take over the entire global stock market.
An example can show the spectacular relative performance in the U.S. since the end of the financial crisis. From 1970 through the end of 2009, the MSCI Europe Index and the S&P 500 had identical annual returns at 9.9 percent each. Since 2010, the S&P 500 is up 13.9 percent a year while the MSCI Europe Index is up just 5.8 percent annually. This has changed the long-term numbers from 1970 to 2017 to 10.5 percent for the S&P and 9.2 percent for the MSCI Europe. That may not seem like a huge amount when just looking at annual returns but this divergence becomes much more pronounced when seen from a total return perspective. After having identical returns from 1970 to 2009, the S&P 500 is now up more than 12,100 percent from 1970 to 2017, while European stocks are up a little more than 6,700 percent. And all of that outperformance has come since 2010 alone.
Valuations and mean reversion are not reliable short- or even intermediate-term market indicators. You can’t use these metrics to time the market or give you the perfect entry or exit points. This is especially true in momentum-driven markets like those we are experiencing now. But when it comes to long-term performance numbers -- the only ones that should matter for the majority of investors -- foreign stocks have higher expected returns than the U.S.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Ben Carlson is director of institutional asset management at Ritholtz Wealth Management. He is the author of "Organizational Alpha: How to Add Value in Institutional Asset Management."
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