Abstract

The decade-long divergence between US equities and those of Europe and Emerging markets has led to an extreme gap in valuations. Extensive research on the relationship between current country level valuations and potential future 10-15 year returns makes a strong case for allocating funds to cheaper markets on a CAPE ratio basis. This article presents the relevant research in regards to valuations and Potential future returns, takes an assessment of current global equity valuations, and provides some ideas on how high net worth individuals, foundations and endowments can position portfolios to take advantage of these long term valuation discrepancies. 

Introduction

The past decade has witnessed a divergence in performance between US equities and their counterparts in Europe and Emerging markets. As you can see below, US large cap equities have outperformed Emerging Markets by over 150% and European equities by over 120%: 

This disparity has resulted in a significant valuation gap between US and other global markets, which, based on research, portends a shift in long term global equity returns, and strengthens the case for the potential benefits of increased geographic diversification. 

Cyclically Adjusted Price-to-Earnings Ratio (CAPE)

The CAPE ratio, first introduced by Robert Shiller, is a valuation metric that accounts for fluctuations in corporate earnings due to business cycles. It is calculated by dividing the current market price of a stock or index by the average inflation-adjusted earnings over the past ten years (Shiller, 2005). Research has shown that the CAPE ratio is inversely related to long-term future returns (Asness, Ilmanen, & Maloney, 2016). Additionally, research by StarCapital AG has been essential in understanding the long term relationship between CAPE ratios and country equity returns.

Links for more context on CAPE: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2736423

StarCapital AG Research: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2736423
‍

_{Price-to-Book Ratio (P/B)}

The Price-to-Book ratio is another valuation metric that compares a company's market value to its book value. A lower P/B ratio may indicate that a stock is undervalued, while a higher ratio suggests that it may be overvalued. Studies have demonstrated correlation between low P/B ratios and higher future returns (Fama & French, 1992). Again StarCapital AG has robust research on P/B and its relationship on a country level to long term returns: ‍

StarCapital AG Research: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2736423

^‍

Current Market Valuations and Returns

_{The Decade-Long Divergence in Returns and Valuation}

As mentioned in the introduction, the past decade has seen the US dramatically outperform the bulk of global equity markets. The closest major market has been Taiwan, but even their ten year cumulative performance of 148% lags the ten year return of US markets by more than 60%: 

10 Year Global Equity Performance 

 On the more extreme end, US total returns have been nearly 250% higher than Brazilian equities. US outperformance is now long in the tooth and many allocators (in our company’s opinion) are moving towards greater international and emerging markets exposure, given stretched valuations in the US and relatively cheaper valuations abroad.

The recent divergence between US equities and those of Europe and Emerging markets can be attributed to several factors, including stronger corporate earnings growth, technological innovation, and accommodative monetary policy in the United States. Consequently, US equity valuations have become stretched relative to other regions, raising concerns about their sustainability and potential impact on future returns.

Despite these very legitimate reasons for the performance discrepancy, much of the outperformance in US markets has been driven by valuation expansion as opposed to other factors: 

From the chart above, you can see that since the financial crisis in 2008, US stocks have become ever more unlinked from other global valuations, with the last few years contributing significantly to the gap.

_{Global Equity Valuations and Their Implications for Long-term Returns}

Currently, the US market is trading at a higher CAPE ratio compared to Europe and Emerging markets, raising the specter of lower future long term returns as compared to their cheaper peers, based on the research highlighted above (Barclays, 2023; Siblis Research, 2023; Investment Moats, 2023): 

As the graphic above illustrates, US markets outpace most other global markets in terms of high valuations. This valuation disparity, coupled with the extensive long term data on valuations and future returns suggests that investors may benefit from diversifying their portfolios across different geographic regions to potentially enhance returns and manage risk.

The Case for Geographic Diversification

_{Lower CAPE and P/B  and Potential Higher Future Returns}

As previously discussed, there is a strong inverse relationship between country-level CAPE and P/B ratios and long-term future returns. By diversifying geographically, investors can capitalize on this relationship by allocating a larger portion of their portfolios to regions with lower CAPE ratios, thereby increasing the potential for higher future returns. Keep in mind that research is most robust for 10-15 year periods, and generally not anything much shorter than that. The two charts below show the long term correlations between CAPE and P/B ratios and future 10-15 year returns: 

Note: All indices referenced above are unmanaged. You cannot invest directly in an index

Both valuation metrics fit a similar long term pattern; markets with extremely high valuations, whether in terms of CAPE or P/B, tend to perform less well over the next decade than those countries with lower valuations. While no factor alone can accurately predict future performance, valuation metrics can provide a good framework for ongoing portfolio construction.

_{Reducing Portfolio Volatility}

Another potential  benefit of geographic diversification stems from lower correlations between foreign markets and US markets. By diversifying investors can build portfolios that are generally less volatile than investing in a single country's equity market. For instance, while global equity correlations tend to change over time, the chart below showing correlation between the S&P 500 and Emerging Markets equities does a good job presenting the fact that, even in normal times, emerging markets equities are not highly correlated to US equities.

European equities, on the other hand, tend to be more correlated to US equities, though they provide diversification in their own right. See here for a general primer of diversification.

_{Exploiting Opportunities in Emerging Markets}

Emerging markets, in particular, offer attractive investment opportunities due to their higher growth potential, favorable demographics, and ongoing structural reforms. These factors can translate into higher corporate earnings growth and, consequently, more attractive equity valuations. By allocating a portion of their portfolios to emerging markets, investors can tap into this potential for enhanced returns and portfolio diversification.

Making the Case for Strategic Asset Allocation Strategies

Strategic asset allocation (SAA) is a long-term investment strategy that establishes target allocations for various asset classes based on an investor's risk tolerance, return objectives, and time horizon. By incorporating geographic diversification into the SAA, investors can achieve a more balanced portfolio with exposure to global equities that offers the potential for enhanced returns and reduced risk.

Implementing Geographic Diversification

_{Exchange-Traded Funds (ETFs) and Index Funds}

ETFs and index funds offer a cost-effective and efficient means to achieve geographic diversification. By investing in region-specific or globally diversified ETFs and index funds, investors can gain exposure to a broad range of international equities while maintaining control over their desired level of geographic allocation.

_{Direct Stock Investments & Direct indexing}

For sophisticated investors with the requisite knowledge and resources, direct stock investments in foreign companies can offer additional opportunities for geographic diversification. This approach enables investors to conduct in-depth research on specific companies and industries to identify potential opportunities for outperformance in international markets. Beyond individual stock strategies, direct indexing can be a highly effective method of both capturing greater diversification, potential long term return and harvesting taxable losses to increase after tax performance.