Valuations Outside of The U.S. Are Favorable
- Year-to-date, the S&P 500 has returned mid-single digit returns, but now valuations are somewhat elevated
- International market valuations are more attractive than U.S. valuations
- Investors should focus on the broad international markets and in the U.S. invest in individual securities and not the major indexes
Through Thursday’s close, the S&P 500 has delivered another good week, up 1.39% and putting the index at an increase of 4.43% for the year. With strong returns in the U.S. over the last year and anemic growth in corporate earnings, the forward price-to-earnings (P/E) ratio has become elevated, but by no means is the P/E ratio at a level that is concerning. It is only 16% greater than the 25-year average; however, compared to the universe of investments, international markets look more attractive.
As we discussed in the Winter 2020 Quarterly Commentary, we decided to overweight international markets slightly compared to our benchmark. From a valuation perspective, international markets are more favorably priced with a P/E ratio of 14.3x on the MSCI ACWI EX-US Index (this includes all markets outside of the U.S.). On the other hand, the S&P 500 has a current P/E ratio of 18.9x. Essentially investors are willing to pay 32% more for U.S. company corporate earnings than earnings that come from companies outside of the U.S.
International markets are trading at the most favorable valuations relative to the U.S. in the last decade as indicated in the chart below.
Valuations have proven to be a good predictor of future long-term returns. A simple example will explain why that is the case; imagine someone offered to pay you $1,000 annually for the next 10 years, if you paid $8,000 today for that stream of cashflows, you would realize an annualized return of 4.3%. However, if you only paid $7,000 for that same stream of cashflows, the return would be 7% annually. This is what the P/E ratio captures, how much does an investor pay for $1 of corporate earnings. The higher the P/E, the lower the expected future return and conversely the lower the P/E, the higher expected return.
At the moment, international markets have a lower P/E ratio as compared to the U.S. and the S&P 500 is trading above its long-term forward P/E average. Therefore, it is expected that over the long-term, international markets will do better than U.S. returns. We have taken a slight overweight to the broad international markets for this reason. On the U.S. front, we don’t think investing in the broad indexes makes sense because of the somewhat elevated P/E ratio, but rather an investor should look for opportunities in stocks that are not overvalued relative to its valuation history. When markets are not cheap, individual security selection becomes more important and that is how we are investing in the U.S. markets.
Robert Luna, Surevest CEO & Chief Investment Strategist, will be on Making Money with Charles Payne to discuss some of the stocks that our research shows are expected to perform well in today’s market environment. Tune in today at the 11a PST hour on the Fox Business channel.