Investors skew their equity exposures toward their home country; that is, they exhibit a home-country bias. According to data from the International Monetary Fund’s Coordinated Portfolio Investment Survey,1 U.S. investors allocated over 70% of their equity assets to the U.S. even though, based on market capitalization, the U.S. represents less than 50% of the global equity opportunity set. This by no means is a U.S.-only phenomenon. Canadian and Australian investors exhibit similar levels of concentration of equity exposures (60%-70%) in their domestic markets despite these markets representing only 3.3% and 2.4% of the opportunity set based on their respective weights in the MSCI ACWI Index.2 The recent strong returns of U.S. vs. non-U.S. stocks is most certainly at the top of the list in explaining the strong preference many currently harbor for U.S. equities.
U.S. and non-U.S. stocks have traded leadership over many cycles and decades. The golden portions of the charts below indicate periods during which U.S. stocks, as measured by the S&P 500 Index3 outperformed their overseas developed peers, as measured by the MSCI EAFE Index.4 In particular, as the far right side of the first graph suggests, both the magnitude and duration of the U.S. outperformance over the last nine and a half years reached extreme levels. The U.S. and emerging equity markets, as measured by the MSCI Emerging Markets (EM) Index5 displayed similar leadership cycles, though over shorter periods of time and with even more dramatic relative performance cycles.
In response, investors drove equity prices significantly higher in the U.S. than outside the U.S. From the end of February 2009 through March of this year, the S&P 500 Index has returned an impressive 18.0% per year, while the MSCI EAFE and MSCI Emerging Market Indexes have delivered 10.8% and 11.2% per annum, respectively. On a cumulative basis over this eight-year period, U.S. stocks rose about 170% more than non-U.S. equities. That is 1.7 times more wealth to sit comfortably within the confines of the U.S.!
Certainly, a portion of the U.S. outperformance is warranted. U.S. equities did not need the recent election to make them great. While the economic recovery since the 2009 recession has been muted, U.S. companies have delivered stronger and more consistent fundamental growth relative to developed and emerging companies, especially during the last few years. Policymakers in the U.S. took aggressive steps during the Global Financial Crisis (GFC), helping the U.S. economy and equity market to recover more quickly. One such step was to require banks to recapitalize their balance sheets (often through painful dilution and write-downs). The same could not be said outside the U.S. The eurozone remains exposed to sovereign credit issues and more leveraged banks. In Japan, aggressive fiscal and monetary actions came eventually but failed to stimulate the slow-growing nation, which continues to face persistent demographic and other structural challenges. Emerging countries (and their currencies) initially benefited as China responded to the GFC aggressively through debt-supported infrastructure spending. However, over the past few years emerging countries have seen their expensive currencies reprice and have had to adjust for slower growth in China and the slowdown’s subsequent adverse impact on commodities prices.
The following chart indicates the strength and steadiness of the earnings recovery in the U.S., as measured by the earnings per share (EPS) of companies included in the S&P 500 Index, compared with companies in the MSCI EAFE Index and the MSCI Emerging Markets Index. U.S. earnings stand 21% higher than at the beginning of 2008, while EAFE earnings have been cut in half and emerging markets earnings are flirting with being flat.
It is no wonder that many investors have been reluctant to shift equity exposures away from the U.S. We would argue this is a classic case of recency bias: Investors are extrapolating the excellent returns U.S. stocks have provided of late far into the future. While most assets appear expensive after many years of strong gains, U.S. equity valuations currently stand far higher than non-U.S. valuations.
Using Shiller’s cyclically adjusted price-to-earnings (CAPE) ratio,6 one of many valuation measures, the following chart illustrates both the expensiveness of U.S. stocks and the relative attractiveness of developed- and emerging-markets equities. A yawning gap has opened up in the relative P/E multiples for these various geographic exposures. Today’s CAPE of 29 times for U.S. equities does not look too stretched in the chart. The second chart, however, puts the expensiveness of the U.S. markets into broader perspective. The market is trading in the top 5% of historical valuations! The only other times U.S. equities have been this expensive on this measure include 1929, the peak of the Internet bubble, and in 2008, just before the GFC. For those inclined to dismiss CAPE, other valuation metrics such as the price-to-sales (P/S) ratio have soared to dizzying heights as well.
Investors have clearly rewarded U.S. companies for their higher earnings growth by paying significantly higher prices for them. Perhaps, though, the market has gotten ahead of itself. Equities are long-duration assets–investors are not just buying stocks for the next few years of earnings, they are buying an earnings stream stretching out for decades. In competitive economies and markets, both valuations (P/E and P/S multiples) and profit margins (return on capital) tend to revert to the mean. While valuation has been a great predictor of return, it unfortunately does not tell us much about the timing in which assets will mean revert to fair or normal levels. We still believe, though, that the price investors pay for an asset is the biggest determinant of the return they will make. The more investors pay, the less they will make.
Rather than buy the comfortable asset, investors should ask, “What’s in the price?” We would argue that the relatively good news in the U.S. is more than reflected in asset prices. Emerging- and developed-markets ex-U.S. stocks look to be more attractively priced (even accounting for higher fundamental risks). In fairness, nothing looks cheap. The best we can say is that value stocks in emerging markets look to be near fair value and that the spread between expected returns for emerging markets value and U.S. stocks is quite wide. In addition, emerging markets offer modestly attractive currencies. It has been our experience that long-term investors able to ride out the invariable market swings benefited by fighting their home country bias and buying emerging markets when relative valuations were attractive.
Today’s provocative valuation disparities should be thoughtfully considered.
- International Monetary Fund, Coordinated Portfolio Investment Survey, June 2016.
- The Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) ex USA Index is a free-float-adjusted market-capitalization-weighted index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. You cannot invest directly in an index.
- The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value-weighted index with each stock’s weight in the index proportionate to its market value. You cannot invest directly in an index.
- The Morgan Stanley Capital International (MSCI) Europe, Australasia, Far East (EAFE) Index is a free-float-adjusted market-capitalization-weighted index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of the following 20 developed markets country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Japan, Hong Kong, Ireland, Israel, Italy, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. You cannot invest directly in an index. For the purposes of this review, equity returns during the period in Japan were eliminated in order remove distortion caused by a 1980s economic bubble. For the purposes of this review, equity returns during the period in Japan were eliminated in order remove distortion caused by a 1980s economic bubble.”
- The Morgan Stanley Capital International (MSCI) Emerging Markets (EM) Index (Net) is a free-float-adjusted market-capitalization-weighted index that is designed to measure the equity market performance of emerging markets. The MSCI EM Index consists of the following 23 emerging markets country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, the Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and United Arab Emirates. You cannot invest directly in an index.
- The cyclically adjusted price-to-earnings ratio, commonly known as CAPE, Shiller P/E, or P/E 10 ratio, is a valuation measure usually applied to the US S&P 500 equity market. It is defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation.