It’s been several weeks since we’ve run through long-term valuation metrics and predicted values for future ten-year returns. With markets, especially indices in the US, having corrected since mid-September, this seems to be a good time to check back in.
As we’ve mentioned several times in the past, we prefer longer-term “normalized” P/E ratios. To come up with a “normalized” earnings number, we take an average of trailing earnings over a designated time frame. Some analysts prefer 5-year average trailing earnings because that time period roughly conforms to a typical business cycle. Professor Robert Shiller of Yale University has famously presented a ten-year normalized earnings number for many years. As it turns out, Professor Shiller may have a point; 10-year normalized P/E ratios have a stronger statistical relationship historically with future 10-year annualized returns. For the US, we’ll present both. For the global indices, we’ll present the 5-year, owing to the fact that the amount of available earnings data for global indices isn’t as robust as the US dataset. The point of “normalizing” earnings is to smooth out the earnings kinks that result from the ebb and flow of the business and earnings cycle. When analyzing returns, we usually refer to “real total 10-year annualized returns.” What does this mean in layman’s terms? We are interested in looking at returns that include dividends (total return) and that take inflation into account (real return).
In the United States, long-term P/E ratios still remain in heady territory. The recent correction has made a slight dent, but predicted values for future annualized returns still remain below historical median. As of this morning (Friday), the 5-year normalized P/E ratio for the US is 21.4x and the 10-year normalized P/E is 20.1x. Historically, the median 5-year P/E is 15.9x and the median 10-year is 16.4x. At these levels, the 5-year model predicts 3.2% real total annualized returns over the next 10 years versus a historical median of 6.4%. The 10-year model predicts 3.8%. Either way, the return environment looks like it could remain subdued in coming years relative to historical returns.
Keeping with the US, we’re fortunate to have agencies that release massive amounts of economic and market data. Because of data released regularly by the Federal Reserve, we’re able to calculate a Q-ratio for the US. The Q-ratio is similar to a traditional price to book value ratio, but uses current market values for corporate net worth instead of the static values we typically find on many balance sheets. Like the normalized P/E ratios above, we can analyze the relationship between historical values and future returns and generate a predicted value. Currently, the Q-ratio in the US is approximately 0.89x versus a historical median of 0.75x. At current levels, predicted ten year real annualized total returns for the US come in at 3.44%, roughly in line with the numbers generated from the normalized P/E ratios. Of note: the statistical relationship between the Q-ratio and future 10-year returns is stronger than the relationship between P/E ratios and returns. Take it all into account and it seems like a 3% to 4% total real return environment is a strong possibility going forward in the US versus the 6.5% return environment we’ve typically witnessed over historical 10-year periods.
Moving to global indices, the picture looks slightly better. The MSCI EAFE index, which covers developed markets in Europe and Asia, currently sports a 5-year normalized P/E of 16.6x. At current levels, predicted future 10-year real total annualized returns come in at approximately 5.5%. The MSCI Emerging Markets index currently trades at a 5-year normalized P/E of 13.8x. Predicted 10-year returns for the emerging markets index are approximately 11%.
With economic and earnings deterioration in Europe and parts of developed Asia over the past few years, market performance has lagged behind US markets. Perhaps investors have “over-discounted” negative outcomes in certain corners of the ex-US developed world. Accordingly, valuations have become more attractive on a relative basis. The same effect is in place in emerging markets. In essence, emerging market indices have been flat over the past three years while the economies continue to grow, albeit at a slower pace that witnessed in the past. As such, emerging market normalized valuations have become attractive relative to US valuations.
None of the major global indices trades at levels one would consider “washed out” or extremely cheap. Ideally, investors would be able to pick up equities at valuations in the single digits. Nonetheless, we continue to maintain that higher valuations in the US means there’s less room for error and more of an air pocket underneath US markets should economic and corporate results not meet expectations. For instance, US earnings expectations for 2013 remain optimistic, as we discussed briefly in our recent monthly commentary. Analysts expect 10% earnings growth in the S&P over the next 12 months, a strong number considering margins remain near peak levels and earnings momentum has stalled for two straight quarters. Investors in higher valued US stocks may be prone to punish earnings “misses” more so than overseas companies where hurdles are generally lower. There’s no shortage of pessimism directed towards overseas developed and emerging stock indices and economies (especially China). On the contrary, global investors have been hiding out in a variety of US asset classes, including equities, while Europe and parts of Asia work though various macroeconomic and political headaches. Now, the US seems to be facing a few macroeconomic and political hurdles of its own.
Recent returns may indicate that a shift is underway. Since the middle of September, the S&P 500 is down 7.3% versus 5.2% for the MSCI EAFE and 3.7% for the MSCI Emerging Markets index. Of course, it’s too early to make ironclad judgments, but this will be a trend worth watching.
