Markets correct, valuations become more attractive and expected returns rise. It's no short cut to quick riches, but paying attention to valuation offers strategic-minded investors the opportunity to improve risk-adjusted returns compared to simply buying and holding.
Savvy investors have long preached no less. Graham and Dodd's Security Analysis is the bible for analyzing securities in search of market prices trading at less than intrinsic value. The academic literature has increasingly come around to this perspective over the past 20 years as well. Buying low and selling high, in short, boasts support from both practitioners and academics. What works for individual securities looks no less appealing for broader measures of equities and asset classes as well.
The devil, of course, is in the details. While it's easy to argue that buying low and selling high is the only way to fly, there's the perennial problem of timing. The mere arrival of higher-than-average dividend yields, or lower-than-average P/E ratios is hardly the investment equivalent of blasting the all-clear signal. Stocks can get cheaper for longer than a sunny optimist assumes. That doesn't mean we should ignore valuation, but instead, we must understand the potential risks as well as rewards that come with shopping for value.
With that in mind, we would like to present a brief history of trailing dividend yields for equity markets in the developed world as of last month's close. As the chart below shows, valuations look relatively more attractive today compared with the past two years. Europe is particularly alluring compared with the U.S., according to S&P/Citigroup Global Equity Indices.
Meanwhile, our second graph below shows that forecasts of P/E ratios for the fiscal year ahead also compare favorably these days relative to the recent past. Europe is also out on front on this metric: its forward P/E dropped to 11.4 as of February's close - the lowest since at least the mid-1990s. (Asia Pacific developed P/E ratios were left out of the second chart because of the absurdly high valuations of a few years back due to Japan.
As a result, a graphic comparison between Asia Pacific developed and other regions is difficult. In any case, recent trends in Asia Pacific developed forward P/Es reflect falling ratios elsewhere in the world. At the end of last month, Asia Pacific developed's forward P/E was 14.2, down from the mid- to high-teens of the past 24 months and currently just slightly above the U.S. forward P/E of 13.9.)
What does it all mean? For starters, equities are becoming relatively more attractive. Of course, they may get even more attractive, which is to say the correction may roll on. We don't know for sure, and neither does any one else. As such, caveat emptor. That said, rest assured that what was overpriced is, for the moment, moving towards being fairly priced and, perhaps, that will lead to inexpensive pricing. The process is underway as we speak, although where it stops, nobody knows.