Strong And Stable, Valuations Edition

It's fun and trendy to point out valuations are elevated for a variety of financial assets these days, though thanks to the global bond market selloff over the last several months all manner of fixed income is showing some honest-to-goodness yield again. For the equities crowd, the "P/E" of the 10 year note (1/yield) is down to its lowest levels since 2011. It's a similar story for the broader Barclays Agg, the widely-followed aggregate for the fixed rate investment grade taxable bond market.

So are equity valuations down to? Why, in fact, yes they are! Thanks to a weaker dollar, stronger US and global growth, and of course tax reform, since the end of 2017 next 12 month estimated earnings are up over 11%, while valuations have dropped 2.2x to 16.2x those next 12 months' estimated earnings for the index. 

We can already hear the hoots of derision at the very idea of using analyst estimates. Calm down, folks, we aren't going to litigate that and we have to use some forward-looking estimate of earnings, so we'll go with that one for now. Analyst earnings are always and everywhere acceptable as a baseline, in this correspondent's view, and can create respectable set-ups to play the contrarian of course. But generally they're a decent way to capture a reasonable expectation of what happens next.

Okay so with that off our chest, we'll ask the question: is the US equity market really overvalued? The 16.2x valuation is pretty aggressive versus the ~11x forward earnings being priced in back in the dark days of autumn 2011, but they're hardly unprecedented. Buying ~16x forward earnings in late 2014 has delivered ~8-9% annualized price returns since, and 16.2x isn't that far from mid-2009 forward valuations. We of course don't need to be explicit about how that turned out for equity investors!

But, but! Isn't the US expensive versus the rest of the world? Sure, that's reasonable. We pulled data for a few different MSCI indices; this isn't a comprehensive sample but should give a rough idea. At 16.39x next 12 month estimated earnings, the US trades at a healthy premium. The MSCI World index trades about a turn lower at 15.42x while Europe enjoys a robust 2+ turn discount at 14.31x. High-growth EM is down at 14.09x, while China (still growing in the mid-single digit range real, give or take some fudging here or there) is 12.30x (note: MSCI China is all H-shares listed in Hong Kong).

The problem is that the US is relatively unique. Sticking with the MSCI indices, Tech's market cap is over 24% of total US market cap versus 16.2% for MSCI World. For EM, that's only 7.1%. Given gangbusters growth, it's pretty reasonable for US Tech to trade at a healthy forward multiple, 17.31x next 12 months' earnings. But wait: MSCI World Tech trades richer than that, at 17.53x! If you want to pay really exorbitant prices for forward earnings in Tech, head across the pond where the MSCI Europe Tech sector trades 20.6x next 12 months' earnings. EM Tech is valued at a similar level. So the US is expensive in aggregate, but its biggest sector actually looks pretty cheap!

This was recently explored in a good post by Lawrence Hamtil. [We also note @modestproposal1 as a frequent contributor to this theme.] The key thing here is that if we want to explore differences in valuations, it behooves us to adjust for the differing sectors; it makes perfect sense for an all-Utilities index to trade at a big discount to an all-Tech index. That's a pretty extreme example, but the intuition should be clear: higher growth should be valued more dear, and the more growth stuffed into an index the more we should be willing to pay for it.

To get things all nice and squared away, we adjusted the MSCI indices from the chart above to get to a nice like-for-like comparison where they all have the same sector weights both now and across time. The US multiple has actually gone up slightly, but so has everywhere else! Except for Australia, everyone else is within 3 turns now, and there's very little daylight between the MSCI World (third-highest) and Canada (lowest). The US still looks expensive, and in a certain sense stands out, but alternatives are all tightly grouped instead of dispersed. 

We're missing one other dimension here. In the charts below we show the next 12 month P/E, adjusted to global sector weightings, for the US, Europe, Japan, China, and EM. The US always retains a premium, but the re-weighting shows that the US investors have actually been quite discerning. At global weights, they've been unwilling to pay more than 19x forward earnings through a variety of market environments. US valuations have been high, but very stable...unlike the rest of the world. 

Our last chart below shows the current percentile of next 12 months earnings multiple for the MSCI indices we've been discussing. Once again, it's pretty hard to look at the US market as ridiculously over-valued. While valuation is certainly elevated, it's been higher about 30% of the time; Europe looks worse by this metric, as do Emerging Markets. Canada and Japan are relatively cheap versus recent years.

Valuation isn't everything. Many punters - especially those in the post-GFC world - have seen margin incinerated on the backs of "high P/E, gotta mean revert" trades. One of the most famous mean reversion advocates folded last year, and for once that sort of about-face didn't mark a major top for a trade. Therefore in our view there isn't much to do here other than to argue there isn't a trade. Sometimes capital saved by not following popular memes is capital earned, to say nothing of the abject frustration of incinerated options premium.

Note: all data for this post is via Bloomberg/author's calculations, value date 4/30/18.