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The U.S. Valuation Premium and the Emerging Market Malaise

December 18, 2015

(Reprinted from the January 2016 edition of the Bath Country Journal and Richfield Times.)

Global equity markets have once again become rocky and emerging-markets stocks have gone from the penthouse to the outhouse. Even though the recent volatility has pulled the U.S. market back to approximately break-even so far in 2015, returns have been very strong over the prior years and pushed valuations to arguably high levels. So what is an investor to do going forward?

10-Year Expected Return  Forecast (After-Inflation)
Intl. Emerging Equity 7.9
Intl. Developed Equity 5.3
REITs 2.5
US Large Equity 1.1
US Core Bond 1.1
US Small Equity 0.4
US Cash -0.2
Source: Research Affiliates LLC. As of 09/30/2015.

Over the 10-year period ended November 2010, the MSCI Emerging Markets Index experienced an annualized return of 15.3% and grew $1 to $4.2. The S&P 500’s annualized return was a more cash-like 0.8% over this same span and grew $1 to a measly $1.08. This anemic return on the S&P 500 is why the 2000s are often referred to as the “Lost Decade.”

However, for the five-year period ended November 2015, the MSCI Emerging Markets index declined by 3.0% annualized while the S&P 500 was in bull-market mode, gaining 14.4% annualized.

The U.S. Premium?

Many have noted over the past several years that the U.S. market appeared to be expensive, based on various ways to value the market. Yet, U.S. companies and market indices continued onward and upward – not so much with robust revenue growth but more so with widening profit margins.  These profit margins came from cost cutting and increasing productivity – doing more with less.

Warren Buffet commented on the cyclicality of profit margins in 1999, “In my opinion, you have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%. One thing keeping the percentage down will be competition, which is alive and well.”

Corporate profits over the last 10 years have averaged more than 40% above Buffet’s prescribed 6% and closer to 8.5% of GDP. Over this time the U.S. has also been consistently more profitable than the rest of the world.

Ben Inker, co-head of asset allocation at GMO recently wrote, “This profitability, however, could be read either of two ways. Either the U.S. has somehow unlocked a secret to permanently higher profitability or this is may be a dangerous time to be investing in the U.S.”

“Even if the U.S. has somehow managed to unlock the secret to permanently high profits and the economy remains solid, it seems unlikely that the secret will remain an entirely U.S. phenomenon. If we imagine a world in which U.S. profitability is able to remain well above historical levels, we would expect non-U.S. companies to begin to copy their American counterparts. In that scenario, we are being too tough on U.S. stocks, but they are still the worst of the global bunch as our forecasts for other equities are similarly underestimated.”

Implications for Investors

It is risky to make a bet that this time will be different. That the U.S. profit margins will continue to stay high and help justify the higher prices of U.S. stocks. That capitalism is perhaps broken and high profits will not induce competition or that competition will not push these margins downward.

Today, the emerging markets index trades below its 2009 lows. Yet despite the decline in price most will tend to perceive emerging markets as riskier…riskier than thinking or unconsciously acting that this time will be different. And while emerging markets appear cheap and poised to provide superior returns in the decade ahead, it is impossible to say that the worst is behind them and whether expectations of the pain to come have been fully priced into these markets.

The coming years are likely to test the mettle of U.S. investors. Returns are likely to be much lower than historical norms and compared to the recent past for U.S. equity markets. Global diversification, patience, discipline, rational thought, and a sound investment philosophy are going to be required in large amounts.

See Also:

12/2013 - Investment Returns: What Should We Expect Going Forward

10/2014 - CAPE Crusader: Market Valuation & Investment Timing

Kevin Kroskey, CFP®, MBA is President of True Wealth Design, an independent investment advisory and financial planning firm that assists individuals and families with their overall wealth management, including retirement planning, tax planning and investment management needs.

 

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