Originally Published June 2, 2017
By Eric Fry
If you’re hoping to find the very best investment opportunities for the next three to five years, you won’t find very many of them inside the S&P 500 Index or the Dow Jones Industrial Average.
Most of today’s best opportunities lie in overseas markets... or in certain pockets of the natural resources markets.
Most U.S. stocks have enjoyed a fantastic eight-year run from their 2009 lows. But as a result of this grand success, they’ve become quite expensive relative to competing investment opportunities around the globe.
Take a good, long look at the chart above. It shows the total market value (i.e., “market cap”) of all U.S. stocks expressed as a percentage of U.S. gross domestic product (GDP). This calculation is called the “Buffett Indicator,” and it’s telling us that U.S. stocks are expensive... very, very expensive.
Mr. Buffett did not invent this valuation gauge, he merely praised it publicly. Back in a 2001 interview with Fortune, Buffett lauded this indicator as the “the best single measure of where valuations stand at any given moment.”
It has been called the Buffett Indicator ever since.
According to this big-picture valuation gauge, a stock market is relatively cheap when its market cap drops below 100% of GDP. Conversely, a stock market is relatively expensive when its market cap climbs above 100% of GDP.
At the stock market lows of 2009, for example, the market cap of all U.S. stocks plummeted to less than 60% of GDP. But today, the U.S. market cap totals a whopping 142% of GDP. That’s more than double the average readings of the last 65 years. Today’s 142% reading is also the second-highest level this metric has ever reached during the last 65 years.
If you need another reason to lighten up on U.S. stocks, take a look at the next chart. It shows the price-to-cash-flow ratio of the S&P 500 Index. The ratio recently soared past the extreme reading it hit in 1999, just before stocks swooned into the deep bear market of 2000 to 2003.
“Cash flow,” in this case, means EBITDA, or earnings before deducting interest, taxes, depreciation and amortization. This profitability metric is very handy because it eliminates the impact of accounting decisions and protocols that differ from company to company.
Taken together, the Buffett Indicator and the S&P 500’s lofty price-to-cash-flow ratio both suggest that the U.S. stock market has “decoupled” from underlying economic trends.
In our industry, this sort of decoupling is called “multiple expansion” - a process that enables share prices to soar, even when the underlying economy isn’t doing much of anything.
Stock prices rise because investors become willing to pay ever-higher prices for each dollar of earnings or cash flow. So, for example, instead of paying $7 for every dollar of a particular stock’s annual cash flow, investors decide to pay $8 per dollar of cash flow, then $9, then $10, etc.
Multiple expansion is fun while it lasts. It makes stocks go up. But there is a dark side to extreme multiple expansion... It often precedes its evil twin, multiple contraction.
After all, investors can decide to pay lower multiples just as easily as they can decide to pay higher multiples, especially if a selling panic takes hold. That’s why multiple expansion is one of the flimsiest of all stock market foundations... and why it’s usually a good idea to tiptoe away from multiple-expanded markets.
Imagine, for example, that the U.S. stock market reverted to its average.
If the S&P 500 index fell to its average price-to-EBITDA ratio of the last 37 years, it would drop more than 30%. The Buffett Indicator presents an even scarier prospect. If U.S. stocks were to return to their average Buffett Indicator readings of the last 65 years, they would plummet more than 50%!
Bottom line: Buying U.S. stocks now is a bit like buying a quart of milk three days before its expiration date. They’ll probably be OK for a little longer, but they might turn sour pretty quickly.
The good news is that my trading system has identified three specific sectors that have entered the opposite phase of their “life cycles.” These sectors have completed long-term bear markets and are on the verge of what could be very explosive gains.
For example, emerging markets have become rich with opportunity once again.
After spending most of the last eight years going nowhere, the MSCI Emerging Markets ETF (NYSEARCA:EEM) finally kicked into gear early last year and started moving decisively higher. Despite this impressive 18-month rally, this index remains well below its 2007 highs.
To illustrate the upside potential of MSCI Emerging Markets, let’s add its valuation data to the price-to-cash-flow chart I presented earlier.
At seven times cash flow (i.e. EBITDA), MSCI Emerging Markets is trading about 40% below the valuation of U.S. stocks. This relatively low valuation, combined with MSCI Emerging Markets’ strengthening upward momentum, makes it a very timely and alluring investment. In fact, I believe this ETF could double over the next three years.
But remember, MSCI Emerging Markets is a fund that holds a large number of securities. So this ETF is not capable of delivering the huge gains that many individual emerging market stocks will deliver over the next year or two.
My trading system has identified specific emerging markets stocks that I expect to soar 500% to 700%. I realize that a prediction like this might sound a bit outlandish. But thanks to a 700% gain in 2016, I won a nationwide investment contest. One of my picks for the contest, Teck Resources (NYSE: TECK), soared 721% in just 11 months.
So gains of this magnitude are certainly possible, especially when you’re shopping in sectors that possess the ideal combination of low valuation and surging upward momentum.
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