With U.S. equity indices pausing their tremendous gains over the last six months, it is prudent to examine relative valuation with other benchmark equity indices globally. While the chart below provides a wealth of information, this analysis was conducted to answer two questions:
1) With multi-speed economic growth occurring in different parts of the world, are these differences in growth rates properly reflected in equity multiples?
2) We have seen dramatic changes in the sovereign bond yields of developed economies, is the economic and fiscal stress these bond yields signal properly reflected in the discount of equity prices?
In a departure from my typical effusive and analytical articles, I offer up only my own observations, and encourage continued discussion about the appropriate relative valuations.
· I do not believe that the S&P 500 (SPY) or Dow Jones Industrial Average (DIA) should be trading at a lower multiple than the Euro Stoxx 50. Earnings growth will be higher in the U.S. than Europe, where it is likely to be negative. The range of outcomes in Europe is also much wider, which should be reflected in the discount rate. Should even the broad equity index of the strongest European economy, Germany, be trading at approximately the same equity multiple as the S&P 500?
· I favor U.K. equities to French equities given their close relative valuation, and believe that there should be a greater relative discount in French shares to British shares. While economic growth in the United Kingdom will continue to be mired in low or zero growth territory, British equities may be an interesting way to play the economic malaise in Europe. If European growth surprises markets to the upside, we should see British stocks outperform alongside their downtrodden neighbors given their low valuation. Earnings for the FTSE 100 ended 2011 at $559.20, 13% above pre-recession levels at year-end 2007, but the index still trades 11% lower than its 2007 close. The Bank of England controls its currency and therefore its monetary policy, placing the country in stark contrast to its euro brethren. As we continue to see aggregate demand plummet in southern Europe while the northern economies, notably German, continue to expand, it will be difficult for the European Central Bank to provide monetary support to the South without stoking inflation in the North.
· While Italy is a notable outlier given the negative earnings of the components of its national benchmark, I believe that the FTSE MIB will continue to outperform Spain's IBEX 35. I have written about this contrast in more detail previously. Summarily, the Italian banking system is in better shape in part because they did not see the real estate collapse that has occurred in Spain, unemployment in Italy is markedly lower, and Italian technocratic governments have shown prior willingness and ability to de-lever.
· Given decelerating growth in China, and the resultant impact this will have on resource-rich Australia, I believe that the U.S. equity benchmarks will outperform the ASX 200 on average over the next several years. One of the predominant questions in markets today is whether China will have a "hard" or "soft" landing. It is the rare case to see this question posited towards Australia, which has not had a year-over-year decline in economic output in twenty years as its mineral and materials exporters have helped feed the tremendous growth of China.
· Japanese equities have traded at the high end of equity multiples in the developed world for an extended period of time in part because extremely low bond yields in Japan have pushed investors into equities and other riskier asset classes. As bond yields have fallen in the rest of the developed world to levels more akin to Japan, equity multiples have not expanded to match. Japan is still the most indebted developed country in the world. Historically, this has mattered less because Japan has been a net exporter, and its current account surplus has allowed Tokyo to finance its debt domestically. Unlike the U.S., whose debt is held in a wide range of international hands, Japanese sovereign debt is owned almost entirely by its people. In early 2012, Japan ran its largest current account deficit in recent history given the strength of the yen relative to the currencies of its traditional trading partners. I prefer U.S. equities to Japanese at these relative valuations. Expect to see Japanese companies use the strength of the yen to buy companies in the United States and Europe, which could provide needed diversification and who trade at much lower multiples.
Investors can occasionally be bogged down in the minutiae of economic data points or a single earnings release. I hope that this article helps readers step back and examine the world and global relative valuation from a more macro vantage point. While global investing is a much more complicated mosaic than the simple framework I have laid out, I hope this chart adds some needed perspective. This research reconfirmed to me that I prefer investing in the United States on a risk-adjusted basis despite its recent out-performance.
Disclosure: I am long SPY.