Swedroe: Non-US Valuations Attractive

October 11, 2017

Those are the forecasted real returns. Using the current earnings yield, the forecasted real return is 4.9% for the United States, 6.6% for developed non-U.S. markets, 6.3% for Europe, 7.1% for Japan and 7.0% for emerging markets.

Either method provides forward-looking return expectations for international stocks that come in about 2 percentage points higher than for U.S. stocks. In addition, those higher forward-looking return expectations are much closer to their historical averages than is the case for U.S. stocks, where the expected real return is well below the historical 7%, especially when using the CAPE 10 methodology.

No Free Lunch

It’s important to recognize that the higher forward-looking return expectations for international stocks are a result of investors expressing their belief that investing in U.S. equities is safer than investing internationally. Thus, higher forward-looking return expectations should not be viewed as a free lunch.

However, investors seeking to increase the forward-looking return expectations of their portfolios can do so by increasing their international allocation rather than by increasing their overall allocation to equities. Doing so would also provide a diversification benefit insofar as it would diversify economic and geopolitical risks associated with investing in U.S. equities.

Today, despite the fact that U.S. equities only make up about 50% of the global market capitalization, on average, U.S. investors hold much higher allocations of U.S. stocks, reflecting the well-documented issue of home-country bias.

All over the world, there’s a strong tendency for investors to believe their country is a safer place to invest and that their country will provide higher equity returns. Those beliefs are inconsistent, as safer investments should have lower, not higher, forward-looking return expectations. And of course, not every country can be the safest or the one with the highest returns.

The long market rally since March 2009 has resulted in a world where there are no equities that appear to be cheap (that is, have historically low valuations).

However, while U.S. valuations are relatively high, international equity valuations appear to be much more in line with long-term averages, providing investors with higher, though not guaranteed, forward-looking return expectations.


Because large-cap stocks are only one equity asset class among many, I thought it worthwhile to show the relative valuations of other asset classes. I’ll use funds from Dimensional Fund Advisors (DFA) to do so, as the firm offers a broad array of international asset class funds. That allows us to compare U.S. stock valuations to developed and emerging market stock valuations in the same broad asset classes: small, large, small value and large value.

The following table shows current value metrics (price-to-earnings and price-to-book ratios) as of Aug. 31. Data is from DFA. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends DFA funds in constructing client portfolios.)



Once again, across all asset classes, U.S. stocks have much higher valuations than both international and emerging market stocks. And as you should expect, international stocks have much higher valuations than emerging markets stocks. The lower valuations of emerging market stocks (and their higher forward-looking return expectations) reflect their riskier nature, for which investors demand a risk premium.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.


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