As the S&P 500 bounces around record levels, observers from Blackstone Group’s President Tony James to Yale Professor Robert Shiller find U.S. stocks overvalued, but the same isn’t true for foreign equities.
“A few foreign markets might be knocking on the door of mild overvaluation, but almost all developed and emerging markets are not overvalued,” says Doug Ramsey, chief investment officer at the Leuthold Group, an institutional research firm in Minneapolis. “Emerging markets generally are on the low end of fair value now.”
BY THE NUMBERS
One measure of value that Ramsey uses is a market’s price-to-earnings ratio, using average earnings for the trailing five years.
“That tends to smooth out year-to-year fluctuations in earnings,” he says.
Using MSCI indexes, U.S. stocks trade for nearly 24 times those earnings. By contrast, the rest of the world trades at less than 19 times earnings, European stocks at about 17 times earnings, and emerging-markets stocks at barely 14 times earnings.
“We see the same pattern in price-to-book value ratios,” Ramsey says. “While U.S. stocks recently were valued at 2.8 times book value, that ratio was 1.8, 1.7, and 1.6 for Europe, worldwide foreign stocks, and emerging markets, respectively.”
There are reasons that U.S. stocks command relatively high valuations, but the gaps are so large that they are difficult to justify, Ramsey says.
“I don’t think investors can go wrong by putting more emphasis on foreign stocks if their expected holding period is three years or longer,” he says. “These measures are prone to a mean reversion.”
Valuation gaps probably will narrow, over the long term, and foreign stocks—especially emerging markets—are in a position to outperform.
GOING ABROAD
Looking at the data, Ramsey thinks that financial advisors and their clients should check their holdings and rebalance or boost foreign allocations, if necessary, as U.S. stocks may have exceeded desired portfolio allocations.
“Holding 30% to 40% of a client’s equities in foreign stocks, developed and emerging, may be a target worth considering,” Ramsey says.
Indeed, Mark Wilson, chief investment officer at the Tarbox Group, a wealth management firm in Newport Beach, Calif., agrees that U.S. stocks are overvalued.
Therefore, his firm is “heavily underweight in U.S. small-caps, due to high valuations and neutral weight in U.S. large-caps. We have a small overweight in developed international and emerging-markets equities,” Wilson says.
Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.
