Global Market Valuations and Expected Returns – March 6, 2014

In January 2014, the U.S. stock market benchmark S&P 500 lost 3.36% after an excellent 2013. The enthusiasm went back as the market gained 4.31% over February. The S&P 500 continuously hit new highs. What is the situation in the other parts of the world? In February, the key indexes in Europe surged. Germany’s DAX index increased 4.14%. France’s CAC-40 index gained 5.82%. The FTSE 100 index was up 4.60%. Stock markets performances in Asia were weak when compared with in Europe. Japan’s NIKKEI 225 moderately decreased 0.49%. Hong Kong’s Hang Seng Index gained 3.64% and China’s SSE Composite index was up 1.14%.

On Nov. 4, 2013, chairman of Oaktree Capital Group LLC, Howard Marks, said in Shanghai that China’s equities are “tremendous bargains” while U.S. stocks are “fairly to fully valued.” He believed just as investors were too optimistic on China’s market three years ago, now they were too pessimistic. Right now the Shanghai Composite's price-to-book ratio is about half of 2010's level and the P/E multiple is 42% lower. “We are investing in Chinese equities along with emerging markets,” Marks said. “Investors have lost all confidence in China.”

In GMO International Active Update Fourth Quarter letter, it said, “Iin fact, we believe there are particularly cheap stocks in Europe, Japan, and Emerging Asia. In Europe, value still resides in companies geared to a domestic recovery. We believe industrials, materials, and financials that have significant business exposure to the European economy represent a compelling opportunity. Many of these companies are in the midst of restructuring, cutting costs, and reducing leverage. Companies that are able to achieve breakeven or even positive cash flow on currently depressed revenue levels should reward investors if the European recovery becomes more robust.

Japan continues to pursue structural reform under Abe’s Three Arrows program. The most important policy remains the first arrow of monetary stimulus intended to create nominal asset price increases. Margins in Japan are still very low and operating leverage is so high that, even with modest restructuring and a modicum of pricing power, corporate profits could improve dramatically. With current earnings, valuation looks fair but if policy measures achieve their goals the market is compellingly cheap. The equity market will continue to favor those companies that should benefit from a modestly devaluing yen such as banks, retailers, and industrials. In the midst of these broader themes there can still be found a cohort of Japanese companies that continue their march toward greater efficiency and higher profitability, and that will reward investors regardless of what happens in the broader economy.

In emerging markets, there is the appearance of extreme value, but those stocks that are optically cheap come with high risk. There are only a few countries in aggregate selling below 10 times earnings and all of them are in the emerging markets: China, Russia, Turkey, and Korea. We are most excited about Korea and Turkey. Korea has been out of favor with investors for several years and, as a result, a number of franchises with strong competitive positions can be bought on the cheap. Turkey has some isolated opportunities but it is a struggle to find enough liquidity to make these ideas impactful. In Russia, value is found primarily in the resource sector and comes with an uncomfortable amount of ongoing geopolitical risk.

China continues to be a worry for us. While the slowing economy has certainly been recognized by markets, the extent of bad loans and hidden leverage in the banking system has the potential for catastrophe. The Chinese economy has yet to fully digest the massive credit expansion thrust upon it by policy makers after the global financial crisis. The middle kingdom could find a way to muddle through, but systemic risk is high.”

In IVA Funds Annual Report, Charles de Vaulx and Chuck de Lardemelle mentioned, “Even though we argued over the past year that equities would probably be the best house in a bad neighborhood, we have not been fully invested in equities and, in fact, we have reduced our allocation to equities and simultaneously raised our cash levels as the year progressed.

In a story on Bloomberg News November1, 2013 (“Federal Reserve’s bubble alarm stuck on snooze”), Jonathan Weil quotes Larry Fink (CEO of BlackRock Inc.): “...it is imperative that the Fed begins to taper... we have seen real bubble-like markets again”; Bill Gross (Pimco): “All risk asset prices are artificially high”; Netflix’s CEO Reed Hastings comparing his company’s stock performance with the “momentum – investor – fueled euphoria”; and Tesla’s CEO Elon Musk saying that his company had “a higher valuation than we have any right to deserve.”

Europe remains difficult for us. The eurozone economics are witnessing some degree of stability but many weaknesses remain (worsening public debt, costly credit, vulnerable banks...).

We have had almost no direct investments in the BRIC countries (Brazil, Russia, India and China) in recent time. However, we made our first investment in Brazil over the period; we also added a few names listed in Hong Kong doing business exclusively in China. But these markets are not cheap enough for us to make large commitments. In China, in particular, we worry about massive misallocation of capital and a potentially moribund banking sector.”

In Third Point’s fourth quarter 2013 investor letter, Daniel Loeb believed Japan would be a high-beta trade. Gains would be driven by BOJ policies and potentially by Japanese citizens investing in the markets in anticipation of inflation. Both scenarios, however, faced a road block in the form of the increasing consumption tax. He expected continued growth and stability in China.

In Steven Romick's Q4 Commentary for FPA Crescent Fund, he mentioned, “Overseas, things weren’t that different. Our increasingly global view includes the performance of foreign stock markets, which generally didn’t fare quite as well as the U.S., with the exception of Japan. The U.S. stock market’s relatively strong showing speaks to the Federal Reserve’s continued aggressively dovish policy stance and that our economy missed estimates by less than most other developed economies. We concede inadequacy in that we don’t know where or when any particular stock market will peak. And interest rates, well, they’ll go up and down. But, we are confident that there will be more volatility in our future and with it, investment opportunity. The CBOE Volatility Index (VIX) reflects a market estimate of future volatility. When compared to the last 24 years, at 12.87, the index is just 14% above its low; 36% below its average; and 71% below its high. If I were a betting man – and I am not – I would wager the index won’t end the year where it started.”

We reviewed the U.S. market valuations and the expected return and found that the U.S. market is expected to return 1.0% to 2.4% a year in the upcoming years. The global market provides a totally different picture. The returns in some countries show as being much higher.

The details of the how to estimate the future market returns of the global market, the data sources and the interpretation of data have all been discussed in great detail in our new page of Global Market Valuations. Please go to that page if you want to learn more and have unanswered questions.

Please note that there are large errors in predicting the future returns of emerging market because not enough historical data is available. These countries may not be able to grow at the same rate as they did before. But in general, the chance of having better future returns are higher for these markets that are traded below historical means than for those that are traded above.

As of March 6, 2014, the expected returns for the global market are shown in the chart below:

Among developed countries, Singapore has the highest expected market returns. Australia sits in the second place. Spain ranks in the third place. The expected returns are in the order of mid-teens a year. Among developing countries, Chinese market is still the highest. The expected return is in the order of 36.6% a year. The detailed return numbers can be seen from the table in the end of the article.

Three factors decide the expected returns of the market. They are economic growth, dividend payment and the current market valuations. If the current market valuation is below its historical mean, the contribution from the reversion of the market valuation to the mean is positive. Otherwise, it is negative.

Among developed countries, contributions from reversion to the mean for Sweden, Canada, UK, Switzerland, U.S. and Germany markets are negative because the stock market in these countries are traded above historical means. For developing countries, only Mexico is negative. The details can be seen in the chart below:

These are the details of the expected returns for the world’s largest markets:

For detailed information and data interpretation, go to the page of Global Market Valuations.

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