The pummeling stocks sustained in October is over, but the carnage has left some wondering whether sky-high valuations in some sectors have overshot realistic expectations for earnings growth. This concern is particularly apt for the small-cap sector, after that groups meteoric rise starting in late 2016.
There seems to be a split in investor sentiment on the future direction of the market and the realistic prospects for continued double-digit profit increases. Some argue that the nine-year bull market still has some steam left and, as such, current valuations, particularly in the tech sector, are not yet unsustainable. There is additional uncertainty over the yield curve and whether the Federal Reserve will stick to its current policy of neutrality or raise rates more than forecast. All of these concerns, it should be noted, are being raised after an unprecedented rise in the market in a zero-interest rate environment.
There are an increasing number of investors who don’t share this sanguine projection of current valuations and are starting to look elsewhere for sustainable growth. Given the uncertainty in the direction of the U.S. market and concerns about the duration of the current economic expansion, bargain hunters have started to look overseas.
Over the past decade, while the S&P 500 enjoyed heady growth rates in excess of 10.8% per year, the MSCI EAFE Index, which measures developing countries, rose only 3.9%; the MSCI Emerging Markets Index returned 5.3% over the same period.
The downside is similarly favorable for a shift to overseas markets: the MSCI Emerging Markets Index as of Oct. 1 has dropped 8% compared with the technology- laden Nasdaq Composite’s loss of 11%.
Given these stark differences in annualized returns, the consensus among many mangers is that foreign equities are significantly cheaper. The outflow of funds to foreign markets is telling. Investors’ portfolio reallocation to emerging markets increased by 13% in November, up from 5% in October, according to a Bank of America Merrill Lynch survey (BAML). Investors’ appetite for global tech stocks dropped to its lowest level since 2009.
The BAML survey found that, at the same time, investor allocation to the global tech sector slid to its lowest level since February 2009, with 18% of investors saying they were overweight in the sector, compared with 25% last month.
Other traditional measures, such as price-earnings multiples, bolster the contention that valuations for foreign stocks are substantially lower.
According to Bloomberg, at the end of October, the price-earnings ratio for the S&P 500 was 16.43, contrasted with 13.39 for the MSCI Europe Index, 10.8 for the MSCI Emerging Markets Index and 12.1 for the MSCI Japan Index.
There is another factor that makes overseas markets additionally enticing. Not only are fundamental financial indicators depressed relative to the U.S., but the cheap prices have enhanced current dividend yields. The current dividend yield of the S&P 500 is 2.3%; MSCI Japan returns 2.45%; MSC Europe, 3.98% and the MSCI Emerging Markets yields 3.21%.
Despite the attractive valuations, high dividend yields and prospects for growth, some analysts are urging caution. There are concerns about the political and economic instability brewing in Europe, particularly with the uncertainty with how the Brexit negotiations will ultimately be resolved.
Some countries present particular uncertainties. The Japanese stock market recently hit a 27-year high and the yen has remained strong, which tends to impact some domestic stocks as these companies are highly dependent on exports.
Finally, there is the always-present risk of foreign currency losses for assets denominated in the domestic country’s currencies.
There is no doubt the U.S. tech sector has lost some of its appeal with many investors, as evidenced by that group's losses for the year. Given the mismatch in revenue expectations and unsustainable valuations, many enterprising investors are looking elsewhere for more certain and stable returns in the foreign markets.
Disclosure: I have no positions in any of the securities referenced in this article.
Read more here:
