Foreign stocks are cheap, US stocks are expensive. It’s a common narrative we hear, but you have to dig a little bit. Sector weights are a major factor when analyzing valuation at a macro level. For US stocks, Information Technology and Communications have a huge position in the overall market. For international equities, Financials are much more prevalent. Naturally, big tech will command higher PE ratios than big banks.
What’s the solution? Well, there really isn’t one, but we can adjust the make-up of the indices to better compare geographical markets. A lot of research outfits perform this analysis, but we have our own take using the PE10 to normalize valuations.
When using the more smoothed PE10 valuation measure and neutralizing sector weights, USA stocks are still very expensive. And, wouldn’t you know it, international equities are still cheap. We equally-weighted sectors for both the US and non-US markets using existing sector valuations.
Let’s keep digging. Our country research finds that almost all sectors feature a valuation discount using the PE10 and when looking at Price-to-book ratios. Real Estate, Consumer Discretionary and Industrials are particularly cheap around other parts of the world versus in the US. This analysis reinforces the thesis that a global investor may want to allocate a significant position away from the US when looking out 5-10 years.
Energy, Staples and Health Care are a few sectors that are somewhat close in valuation between US and non-US stocks, but even those show as being at a minor discount globally.
Where exactly do foreign equities stand versus US stocks right now? Our data suggests developed market (ex-US) stocks trade at a 50-60% discount to the US. When sector-neutralizing the markets, the valuation discount dips – but not by much. The difference becomes about 40-50%. Putting some multiples to that, the USA’s PE10 ratio using an equal-weight sector approach yields a multiple of 29x versus about 18x for international developed markets.
And the valuation discounts grow when comparing US to Asia (ex-Japan) and US versus Emerging Markets.
So what does this mean for investors? Indeed foreign equities are a better value that US stocks right now. While anything can happen in the near-term, the likely outcome in the following 5-10 years is that international markets will outperform the US market – particularly US large caps which are very expensive. We reflect this sentiment in our capital market assumptions.
It hasn’t always been like this. The late 1980s were a boom period for the ‘rest of world’ index, and Japan was the epicenter of heightened valuations. Foreign stocks traded at a whopping 150% premium to US markets when comparing price-to-book ratios. The PE10, which again smooths earnings, was still suggesting a large 40% premium. The international premium eroded rather quickly during the 1990s US tech boom. It goes to show that valuation differences between US and non-US stocks can ebb & flow over time and reach extreme levels.
Know what you own - the US market is obviously concentrated in big cap tech. The top 10 holdings of the overall US stock market make up 23% of total market cap – driven of course by FAAMG (or whichever acronym you prefer). The median market cap is about $90 billion versus just $25 billion for the ex-US index. So sector differences play a small role, but so too does the size factor.
Here’s the point – A common “actually…” rebuttal to the narrative that ex-US stocks are a better value than US stocks is sector weight differences. We find that ‘actually…’ does not hold water. While sector-neutralizing reduces the foreign valuation discount, ex-US stocks remain materially cheaper versus US equities.
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