Global Market Valuations And Expected Returns - August 6, 2014

In January 2014, the U.S. stock market benchmark S&P 500 lost 3.36% after the excellent 2013. The enthusiasm went back as the market gained 4.31% over February. In March, it went up only 0.69%. In April, it was about even for the whole month. In May, the market gained 2.10% and in June, the market benchmark S&P 500 went up 1.91%. However, in July, the market went down by 1.51%.

What is the situation in the other parts of the world? In July, the key indexes in Europe had negative return figures. Germany’s DAX index declined 4.33%. France’s CAC-40 index lost 4.00%. The FTSE 100 index moderately went down by 0.20%. Stock markets performances in Asia were very strong. Japan’s NIKKEI 225 gained 3.03%. Hong Kong’s Hang Seng Index surged 6.75% and China’s SSE Composite index surged 7.48%.

In Invesco European Growth Fund’s Second Quarter 2014 Commentary, it said, “After a brief pause in the first quarter, international equity markets moved higher, ending the second quarter of 2014 with positive absolute returns across the board. Canada and the UK were the best performing major markets, while both Europe excluding the UK and developed Asia lagged. Emerging markets also performed well as investors began to anticipate an end to negative earnings revisions. Overall, the world seems to be moving from a market driven by Central Bank actions, as evidenced by 2013’s higher beta performance, to a market that focuses more on less volatile companies with durable earnings growth and trading at reasonable prices. From a broad market perspective, European valuation levels appear favorable relative to other regions but earnings have yet to see a normal recovery from the recession. Japan’s correction so far this year has improved valuations, but critical structural reforms in Japan may prove to be elusive in the near term and quality opportunities remain scarce. Emerging markets began to show signs of stabilization, which has increased focus on the region, but most emerging market economics remain fragile, and economic recovery across the region is expected to be inconsistent. In sum, we continue to believe that improvements in broad corporate and economic fundamentals are struggling to keep pace with rising expectations for economic acceleration in the second half of 2014.”

In Charles de Vaulx’s IVA International Fund Q2 2014 Review, it mentioned, “Global equity markets continued to move higher this period with the S&P 500 Index reaching a record high close in mid-June despite a still murky economic picture. Towards the end of the quarter, it was announced that U.S. GDP growth fell -2.9% in the first quarter of 2014 and the Bank for International Settlements (BIS) warned in its annual report published in June that “buoyant financial markets are out of sync with the shaky global economic and geopolitical outlook.” Discovering new securities to buy remains difficult because we view equity markets as fully valued; however, we continue to search stock by stock. Over the quarter we found a few opportunities in equities, namely in South Korea, in consumer discretionary, and in technology, which brought our equity exposure up to 58.6% on June 30 from 54.4% on March 31. Since a few securities reached or are close to what we view as their intrinsic value, we trimmed or sold those, mostly in France. Our cash exposure totaled 26.2% at quarter-end, down from 29.3% last quarter. We remain comfortable with our cash position despite rising markets and we believe that, to see the real return on our cash, one will have to see how we put it to work years from now. Only then can the true return on cash be fully understood and measured. We increased our exposure to a few equities in India, China (through Hong Kong listed equities) and Hong Kong over the period that we believe are still trading at reasonable valuations. This brought our exposure to these three countries up to 7.2% at quarter-end from 5.8% on March 31. In Japan, equity markets are having a slower start to this year, following the Nikkei 225 Index rising over 50% (in Japanese yen) in 2013. Despite the strong equity market performance last year, we still think some companies remain reasonably priced in Japan and over the quarter we added to a few existing positions that we think are still attractively valued, bringing our Japanese equity exposure up to 18.3% from 16.4% last quarter.”

In David Herro’s Second Quarter 2014 Shareholder Letter, it said, “For some time now, we have been quite heavily exposed to European equities. There is nothing special about Europe that we like or dislike; we are simply bottom-up investors who focus on the business fundamentals of the companies in which we are invested, as opposed to the postal code of their corporate headquarters. What really matters to us are the durability, velocity and quality of a particular company’s free cash flow stream over time. Many market watchers are frequently distracted by macro, geopolitical and regulatory events that often influence sentiment or allude to a more “cyclical” impact, but do not structurally affect a company’s future stream of free cash. As such, these events often do not have long-term fundamental impacts on business value. For example, Russia’s annexation of Crimea certainly has unsettled and weakened European markets, but it has not rattled our view on our holdings of European-based companies.

Though the Japanese stock market has been the worst-performing developed market to date in 2014, there seem to be some positive reforms worth commenting on. In 2014, the situation is a bit different. Share prices have been weak and business value has gently increased, again opening the “value gap.” The positive reforms in Japan involve government policy that aims to significantly improve corporate governance and lower corporate tax rates. We are especially pleased that the Japanese government is committed to using the clout of its $1.4 trillion pension fund to enact changes in corporate behavior, urging such factors as better capital allocation, as well as more independent corporate board composition. Though the Abe administration initially appeared to be slow in implementing a structural and corporate reform agenda, it seems to have acquired a “second wind.”

In Daniel Loeb’s Third Point Second Quarter 2014 Investor Letter, he said, “Exposure to Japan has been our biggest source of losses in 2014. A strong year-end rally and frustration over the pace of reforms caused the Japanese markets to correct by more than 10% in the First Quarter. Our team’s trip to the region in May and meetings with senior officials confirmed that the desire for reform is acute and widespread. Though Prime Minister Abe and other leaders appear committed to changing Japan, shifts of this magnitude do not happen overnight. Moving a country from a culture of persistent deflation to an inflationary environment will only happen slowly. We are seeing early signs that the government’s growing support for improved corporate governance and increased focus on shareholder returns is impacting Japanese companies, a few of which have adopted measures addressing these areas recently. We continue to find compelling individual situations in Japan and, while each has an event-driven component, we recognize that the macroeconomic backdrop will factor significantly in the outcomes of these investments. We think recent macro headwinds will become tailwinds again towards year-end but remain vigilant about inaction. A failure of Abenomics would likely mean that it is time to move on.”

In Jean-Marie Eveillard’s First Eagle Global Fund Second Quarter 2014 Commentary, it mentioned, “We have previously shared our concerns about China, and we continue to see worrisome signs of potential destabilization—not least of which is that China’s six month moving average of monetary growth is at a five year low. Real estate transactional data in Beijing is weak. We have also seen further declines in iron ore pricing—a troubling indicator given China accounts for approximately half of global iron ore demand. In Europe, we continue to worry about the potential for deflation. Not only has credit growth failed to revive in Europe, but the currency has been on a strengthening trend for the past 12 to 18 months, forcing policy makers to make expansive comments regarding monetary policy. The European Central Bank (ECB) continues to extend wholesale funding to the European banks in order to revive credit growth, but the impact of this remains uncertain.”

We reviewed the U.S. market valuations and the expected return and found that the U.S. market is expected to return 1.1-1.9% 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 how to estimate the future market returns of the global market, the data sources, the interpretation of data have all been discussed in great details 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 an 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 August 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, which is 16.7%. Australia sits in the second place. Spain ranks in the third place with an annualized return of 10.5%. 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 36.4% a year.

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

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 Korea, Sweden, Canada, UK, Switzerland, USA, and Germany markets are negative because the stock markets in these countries are traded above historical means. For developing countries, Indonesia and Mexico are negative. The details can be seen in the chart below:

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

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