Swedroe: Non-US Valuations Attractive

October 11, 2017

With the Shiller CAPE 10 above 30 (to be precise, 30.7 as I write this), it’s likely you have seen an interview or read an article in which some “guru” claims the market is on its last legs due to excessive valuations.

Certainly, current valuations are high relative to their long-term historical averages, which means forward-looking return expectations are lower. However, that doesn’t necessarily mean the market is overvalued, just relatively expensive.

To get a better idea of how expensive U.S. equities are, I’ll compare today’s valuation metrics to some longer-term averages as provided by J.P. Morgan Asset Management in its third-quarter 2017 Guide to the Markets. Current data for the Vanguard S&P 500 ETF (VOO) is from Morningstar as of Aug. 31, 2017.



While today’s forward-looking price-to-earnings (P/E) ratio is higher than the 25-year average, the dividend yield is the same as its 20-year average, and the price-to-book (P/B) ratio is the same as its 25-year average.

In terms of forward-looking real returns, we can use the CAPE 10 earnings yield and the current earnings yield—they have approximately the same explanatory power for 10-year returns.

Using the CAPE 10 provides an estimate of real returns of 3.3%. Using the current P/E provides a higher estimated real return of 4.9%. With a negative current real yield on one-month Treasury bills, that still offers investors a fairly large equity risk premium. Thus, it seems to me, it’s hard to argue that markets are overvalued; rather, they are just more highly valued than has been the case historically.

What About The Rest Of The World?

Because investors are not limited to investing only in U.S. equities, I’ll examine global equity valuations so that we can see how expensive they are in comparison. And I’ll also look at their forward-looking return expectations.

Historical data is from J.P. Morgan Asset Management’s third-quarter 2017 report, and current data is from Morningstar as of Aug. 31 using the Vanguard FTSE Developed Markets ETF (VEA) for the non-U.S. developed markets, the Vanguard FTSE Europe ETF (VGK) for Europe, the iShares MSCI Japan ETF (EWJ) for Japan and the Vanguard FTSE Emerging Markets ETF (VWO) for emerging markets.



As you can see, valuations outside of the United States are quite a bit lower, and they look more favorable relative to their 25-year averages. In the case of emerging markets, although J.P. Morgan did not provide the P/E ratio’s 25-year average (the current P/E of VWO is 14.2), it did provide the P/B ratio’s 25-year average. It was 1.7, the same as it is today for VWO.

We can also examine the relative valuations of U.S. and international stocks from the perspective of P/B ratios. The current P/B of U.S. stocks (VOO) is 2.9 versus just 1.6 for VEA, 1.8 for VGK, 1.4 for EWJ and 1.7 for VWO. Again, we see U.S. valuations are much higher.

In terms of forward-looking return expectations, we can use the same two methods we did for the U.S. calculations. The current CAPE 10 for U.S. stocks is 30.7, providing an earnings yield of 3.3%. Using data from AQR Capital Management, as of June 30, 2017, the CAPE 10 earnings yield for developed markets was 5.4% and for the emerging markets it was 7.0%.


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