U.S. stocks appear expensive. But where to consider investing instead?
As we entered this year, a common theme ran through many capital market forecasts: “Expect lower investment returns because equity valuations are high and interest rates are low.” Interest rate levels and fixed income returns have a direct relationship. The current low rates equate to low yields for fixed income instruments. If interest rates increase during the year, as many (including Russell Investments) expect they will, the combination of subsequent price decreases and low yields will lead to modest fixed income returns.
The relationship between interest rates and equities isn’t quite as tight, but high valuations still have a significant impact on expected returns. The U.S. equity market (S&P 500® Index) has experienced a strong run of results since global markets bottomed in March of 2009. This run has created high market valuations within the U.S. Using the Robert Schiller Cyclically Adjusted Price-to-Earnings (CAPE) valuation, the December 2016 CAPE for the U.S. stock market is 28.3 – putting current valuations within the top 6th percentile for the last 90 years. This level of valuations has only been reached twice before: in the late 1920’s and 1990’s. For those too young to remember, these periods were followed by the Great Depression and the Tech Bust, respectively. History has demonstrated that high valuations tend to be followed by lower than average returns.
This does not bode well for U.S. equity return projections for the foreseeable future. However, just because U.S. stocks appear expensive, doesn’t mean all stocks are expensive. If we move outside the U.S. and consider international equity markets, the valuation picture is different. The two charts that follow show valuation comparisons for some of the largest developed markets and emerging markets, as well as for collective groups, as measured by the MSCI EAFE Index and MSCI Emerging Markets Index.
A few items standout on these charts – and they don’t bode especially well for U.S. equity expectations.
- The U.S. stock market appears to be the most expensive market at an absolute level.
- The U.S. stock market is currently the only one of the largest markets with valuations above its long-term average – and it’s beating that historical average by a notable 75%.
- In contrast, the MSCI EAFE Index is currently valued at 40% below its historical average.
- The MSCI Emerging Markets Index appears to be trading at a similar discount to EAFE relative to individual country and collective histories.
The bottom line
Lower valuations in and of themselves do not guarantee a better future return – at times, they are justified due to market and economic circumstances. However, history has demonstrated that the price paid for an investment has a significant impact on the future return that an investor may earn. Against a backdrop of expensive U.S. capital markets, long-term investors with commensurate risk tolerance may want to consider diversifying part of their portfolio beyond U.S. borders.