Earlier this month, market watchers at publications like The Wall Street Journal and Barron's questioned whether the stock market was overvalued. Some would argue that their concerns were validated last week when equities began to sell off.
Although I believe that stocks are vulnerable and likely to experience increased volatility in the near term, there are two reasons why I don't think global equity valuations are excessive enough to prevent further gains:
- From a broad global and long-term perspective, it's hard to argue that stocks are expensive. Most of the articles on the subject of value have focused exclusively on U.S. stocks. This is a mistake. The U.S. represents less than 25% of global gross domestic product (GDP) and less than 50% of a global equity benchmark, the MSCI All Country World Index. As such, any discussion of equity valuations needs to take a broader perspective. And on that score, stocks are trading at a discount. As of mid-August, the MSCI All Country World Index was trading at 2x book value and 16.5x trailing earnings, valuations less than long-term averages.
- Stocks still look much better than the alternatives. Putting stock valuation in context also means viewing it relative to bonds. While bond yields have increased lately, they are still close to historic lows. This is evident when you compare the yield on a corporate bond index to a broad global equity benchmark's earnings yield, the inverse of the price-to-earnings ratio. Based on this exercise, stocks still look cheap relative to bonds. The MSCI All Country World Index yields about 0.5% more than a corporate bond index. While this is off considerably from two years ago, when stocks were at their lows and a genuine bargain, it's still well above the long-term earnings yield average of -2%.
In short, despite this year's rally, global equities are still inexpensive by most measures. This doesn't imply that stocks are likely to continue to produce double-digit returns over the next year, but it does mean that valuations aren't an impediment to global (both U.S. and non-U.S.) stocks moving higher. And even the more modest mid- to high-single-digit equity returns I expect over the next year are likely to significantly outperform bonds and cash.
To be sure, while it's important to consider a global perspective when determining whether stocks are overpriced, the articles did accurately highlight that U.S. stocks look more stretched than their international counterparts. The United States -- based on price-to-book value -- trades at a near 50% premium to other developed countries. Some of this premium is justified given faster U.S. growth, higher U.S. profitability and less headline risk out of the U.S. than out of Europe or China. But that said, U.S. valuations still look a bit expensive.
This doesn't mean that investors should avoid allocating more to equities altogether. I advocate that those looking for a bargain consider Europe and emerging markets. While both market segments will face near-term headwinds, each of these regions can still make a credible claim to being a value play. These markets are accessible through funds like the iShares Europe ETF (IEV) and the iShares MSCI Emerging Markets Minimum Volatility ETF (EEMV).