Hedley Market Commentary - August 2019

Over the past few years, the US equity market has handsomely outperformed many other developed world and even emerging markets through a combination of better domestic economic growth and superior earnings growth, in part, because of its preponderance of ‘emerging’ stocks such as Apple, Google etc.

The chart (below) compares the total return of the S&P 500 index to the MSCI All country ex US index. The primary source of outperformance comes from an expansion of the price to earnings multiple (PE ratio) compared to global stocks, especially as we have witnessed some higher earnings growth, particularly when compared to the developed world component. However, while some premium to the developed world may be justified by the more beneficial earnings outlook, this is now getting to extreme proportions when viewed from an historical context.

Global stocks are close to their average long-term historical valuations whereas the US market is richer based on most criteria. A reversion to mean valuations would result in the strong under-performance of the US market vis-a-vis international stocks.

The Shiller CAPE (Cyclically Adjusted Price Earnings) Ratio (below) is the opposite of the forward P/E Ratio. Rather than looking at 1-year forward profit expectations, it looks at the trailing average of the last 10 years of GAAP earnings. The purpose of using a long-term average is to remove the cyclical effect on corporate earnings due to the business cycle.

The Shiller CAPE ratio indicates stocks are rich to their history. The current average ratio is 34 times 10-year average earnings, compared to a multiple of 25.6 since 1990. The Shiller P/E indicates the equity market is rich to its recent history, and very expensive relative to the inception of the data collection.

Finally, another way to value the equity market is to look at the total market capitalization of all stocks compared to GDP . Warren Buffett has referred to this indicator in the past, saying "it is probably the best single measure of where valuations stand at any given moment." Globalization, profit margins and the level of interest rates all probably have something to do with the current level. But at this moment, the measure indicates US stocks are at their richest level in the last 30 years.