It’s one of the most fundamental and enduring relationships in finance. As fear and risk rise, the valuations become more enticing. When all hope is gone, and the last bull throws in the towel, the prospective returns are probably at their highest.
Simple enough, right? The lesson: buy at maximum pessimism or when blood runs in the street, to quote the infamous Rothschild axiom. Sound advice, and perhaps the only true piece of wisdom for dealing with the capital markets. Alas, it’s devilishly difficult to pull off. One reason: no one knows where the bottom is except with the benefit of hindsight.
Another reason: investors tend to be human, and humans tend to trip over that emotion thing every now and again.
So it goes. Pessimism rises, and the more it rises the more likely higher expected returns will be ignored. Of course, there’s always a reason to ignore the seemingly higher odds of richer prospective performance, and much of that has to do with negative signs on recent trailing returns. It’s tempting to think that because recent history has thrown us a pair of concrete shoes, it’ll continue to do so for the foreseeable future. The effect works in reverse, of course: positive returns are expected to continue after a long string of gains in the recent past.
An antidote to giving recent performance too much weight in your strategic decision making comes by way of relative valuation. That includes trailing dividend yields among the major regions of the world. As per our chart below, dividend yields are up in the developed world’s capital markets, as per data from S&P/Citigroup Global Equity Indices through the end of last month. Europe in particular offers comparatively rich yields.
The U.S., by contrast, looks a lot less compelling on a dividend-yield basis. That doesn’t mean that domestic stocks won’t outperform European equities. But if we limit ourselves to what we know, the numbers speak for themselves.
Of course, investing isn’t so easy as picking the highest yielding regions, much less the highest-yield stock. Yes, it’s a critical factor, but risk premiums are opportunities, not guarantees.
Indeed, valuation metrics can be tricky, particularly in bear markets. The U.S. is a case in point. Although the stock market has fallen sharply in America since last October, that hasn’t led to a more compelling valuation across the board of the various metrics. As our second chart below shows, the U.S. is alone among the major regions of the developed world’s equity markets in posting sharply higher p/e ratios.
What’s going on? Earnings are falling faster than prices in the U.S., the New York Times reports: “In the first quarter this year, earnings of the S.& P. 500 sank 17.5 percent, according to Thomson Financial. But the index, excluding dividends, itself declined 9.9 percent. And in the second quarter, corporate profits declined by an estimated 22 percent while stock prices fell by a much more modest 3.2 percent.”
Some analysts argue that p/e isn’t a great metric to use for calling bear-market bottoms and so its surge of late isn’t all that relevant. In fact, one research paper that passed our desk today claims that the high p/e in the U.S. is a buy signal. Perhaps, although based on the above chart, the double whammy of falling prices and even faster falling earnings in the U.S. doesn’t appear to be harassing other markets, or so the falling p/e ratios elsewhere suggest. Meanwhile, consider that the U.S. stock market’s trailing dividend yield is the lowest in the developed world.
That leaves the outlook for stronger earnings growth as the last best hope for U.S. stock market on a relative basis. And based on history, there’s a case for thinking the U.S. growth machine will outdistance the competitors among the mature economies. Of course, now we’re in the realm of speculation, and so all the usual caveats apply.
Yes, a hefty allocation to U.S. equities still looks prudent on a long-term basis, particularly if you compare the prospect for American stocks today vs. last October. But given the above analysis, we’re not yet convinced that this is the time to bet the farm on U.S. stocks.