Are Stocks Overvalued? Or Why Global Diversification is More Important Than Ever

Global Stock Market Valuations

CAPE/Shiller PE for Selected Countries and Markets

Japan (28.1)
United States (26.0)
Switzerland (23.1)
Developed Markets (21.8)
Global Stock Market (21.1)
Canada (20.4)
Germany (19.9)
Hong Kong (19.0)
France (17.5)
Developed Europe (16.5)
Emerging Markets (16.5)
BRIC* (15.2)
United Kingdom (14.0)

*BRIC = Brazil, Russia, India, and China
Source: StarCapital. Data as of 4/30/2015.

If I had to choose one word to describe how most investors view the stock market today, it would probably be frothy. We are now more than six years into the current bull market following the painful Great Recession of 2007 to 2009.

The S&P 500 index, which bottomed out around 735 in February of 2009, now stands at almost 2,100. Even more incredibly, five of the past six calendar years have produced double-digit positive returns for the index.

Of course any time the stock market is going up, so-called experts come out of the woodwork to remind us that their crystal balls are forecasting a pullback. In fact, the headline on just the other week was, “Stock market correction by October: Strategist.”

Unsurprisingly, many investors are concerned stocks are overvalued and that we are headed for an inevitable downturn. This can lead to some very poor decisions, with investors bailing out of stocks or seeking refuge in investments they don’t fully understand.

The Failure of Forecasts

The trouble with these predictions is two-fold:

  1. Extensive research has shown that forecasters are wrong more often then they are right (see Guru Grades compiled by CXO Advisory Group).
  2. Many of these experts have been calling for the bear to awake from hibernation every year since the bull market began. At some point someone will “correctly call the downturn,” but that is a pretty obvious instance of a broken clock being right twice a day.

Nonetheless, even if attempting to time the market is a fool’s errand, the valuation of the stock market is indeed important.

Although valuations aren’t of much value for predicting near-term shifts in the market, they do a pretty good job of setting proper expectations for long-term returns. Namely, when valuations are high, expected returns are lower. Conversely, when valuations are low, expected returns are high.

Understanding this is important both from a planning perspective and also as a reminder of how critical it is for investors to select the right asset allocation and embrace diversification.

What is a Valuation Ratio?

One not too surprising result of the bull market in stocks has been a surge in measurements of stock market valuation, often known as valuation ratios. Valuation ratios attempt to measure the relative “richness” or “cheapness” of a company or index.

The most common ratio is known as price-to-earnings or “P/E.” P/E is calculated by dividing a stock’s price (the numerator) by the company’s latest twelve months earnings (the denominator).

P/E tends to be quite volatile because the calculation only uses a single year of corporate earnings. Thus, although it provides some insight into the relative valuation of a company or index, it isn’t terribly helpful.

Robert Shiller to the Rescue

In order to alleviate this volatility and normalize the peaks and valleys of the business cycle and the economy, several alternative valuation ratios can be analyzed.

Probably the most well-respected by academics and industry professionals alike is a ratio known as cyclically adjusted price-to-earnings, or “CAPE.” Rather than using a single year of earnings, CAPE considers the 10-year moving average, which results in more reliable comparisons from year-to-year.

CAPE is often referred to as “Shiller PE,” as the ratio can be traced back to Nobel Prize winning economist and Yale professor, Robert Shiller. CAPE allows us to compare the current valuation of the stock market relative to history and it also provides a helpful framework for comparing stock markets in one country versus another.

U.S. Stocks are Relatively Expensive

The chart above summarizes the current CAPE ratio for some of the largest stock markets around the world, as well as a few of the more common country groupings (e.g. emerging markets).

Not surprisingly, the U.S. is near the top of the list, with a CAPE of around 26. This is roughly 60% higher than its long-term average and puts the current market firmly in the “expensive” category.

However, take a look at the rest of the chart. First, every country other than Japan and Denmark (not in the chart) is currently “cheaper” on a relative basis than the U.S.

Second, large, easily investable segments of the global stock market are priced much lower than U.S. stocks. For example, the CAPE ratio for Developed Europe (which comprises countries like Germany and France) and Emerging Markets are both hovering around 16.5. This is nearly 40% cheaper on a relative basis than U.S. markets.

Finally, note that the aggregate CAPE of the entire world stock market (including the U.S.) is around 21. Of the more than 40 investable stock markets around the globe, the majority are priced below this mark.

Global Diversification is the Right Strategy

I am an unabashed supporter of global diversification. There, I said it.

Not only are the benefits of diversifying your portfolio around the globe well-documented in the academic literature (see one of my favorite papers on the subject here), most investors are heavily overweighted in U.S. stocks.

It is critical for investors to understand that the U.S. makes up only about 50% of the world’s stock market value. The remainder lies in more than 40 other countries.

If diversification is your strategy (which I hope it is), you should take a very close look at your portfolio to figure out what your allocation is between U.S. and non-U.S. stocks. Most investors will find that their portfolios are dominated by U.S. companies, with just a small percentage allocated to international stocks. If you’re not sure how to do this, I can review your portfolio for you.

Ultimately, global diversification is a key tenet of a well-designed portfolio no matter how the market is valued. However, if you are particularly concerned about where the U.S. market is headed, there is no better time than now to reevaluate your asset allocation to ensure you are properly diversified.

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