A Look at Foreign Markets: Cheap vs. Expensive
Posted by Larry Brundage on January 19, 2012
Following dismal performance during the third quarter of 2011, the international equity markets churned around some but finally ended up 4.9%. That is not too bad for a quarter, but it certainly was not enough to offset the damage from earlier in the year, as the final tally for the full year as shown by ETFs was -12.2%. The following graph of the iShares ETF, which tracks the MSCI EAFE index (non-U.S. developed country stocks) tells the story.
Data Source: Bloomberg L.P.
The emerging markets seemed to be a magnified version of the developed markets as they were up 9.1% in the fourth quarter, but were down 18.8% for the full year. Although it may have felt like this is what we were experiencing in the U.S. too, in fact US markets significantly outperformed international markets for both the fourth quarter (up 11.6%) and for the full year (up 1.9%).
Much of the outperformance can be attributed to our perceived position as the world’s safe haven. Thus while Europe looked over the edge of the financial abyss as it stalled its way to coming up with a mediocre solution to the debt problems of the peripheral countries and Asia panicked that one of their largest customers for their export driven economies would actually fall into the abyss, investors fled to the safety of the U.S. markets. While it is reasonable to say that the U.S. equity markets were a beneficiary of this, actually the largest beneficiary was the U.S. bond market, which was up 7.8% as measured by the Citigroup Broad Investment Grade index.
So where do the markets go from here? Let’s take a look at Europe first. If you were to base your forecast of the European equity markets on what you expect from their economies, things might look bleak. The contraction in government spending that is necessary to reduce deficit spending will certainly put a damper on economic growth. That is not only a 2012 phenomenon, but a situation that may be around for several years. But, if you haven’t noticed already, economists make lousy market forecasters. (Actually they make lousy economic forecasters too, but that is another topic.) The problem with looking just at the expected economic growth in Europe is that it ignores how cheap the European equity markets are. One simple way to measure how cheap or expensive an equity market is is to look at the ratio of the market price to the earnings of the companies in that market. Or more simply put, look at the P/E ratio.
To set the stage for this discussion, look at the P/E ratio for the S&P 500. It is currently 13.65. Historically it has ranged from 10 to 25 most of the time, although it has been as low as 6 or 7 and over 30 at times. Generally there is an inverse relationship between P/E ratios and interest rates. So one would expect that in times like this, when interest rates are particularly low, that P/E ratios would be somewhat higher. In Europe the broad index for large companies across the continent is the Euro Stock 50 which has a current P/E ratio of 11. Furthermore the main indexes for Germany, France and England have P/E ratios of 10.3, 9.4 and 10.0 respectively. So Europe is not only cheap relative to the United States, it is cheap relative to historical pricing. We believe that the cheapness of these markets will help to put a floor under the current levels and actually allow them to grow at a modest rate as they started to do in the fourth quarter. For U.S. investors some of that performance may be mitigated if the Euro continues to deteriorate relative to the dollar. The recent announcement that France and Austria are being downgraded by S&P may hasten that deterioration; on the other hand the U.S. has its own economic and fiscal problems which could hurt the dollar if markets turn their focus from Europe to the U.S.
The Asian markets are a little more difficult to predict. There are three main items that look like they will affect markets there. First there is a mixture of cheap and expensive markets. For example here are some of the P/E ratios: Japan (Nikkei) 16.6, Australia (S&P/ASX 200) 13.5, Taiwan (TAIEX) 16.34, South Korea (Kospi) 27.3, China (Shanghai Composite) 11.8 and India (Sensex) 14.7. This disparity would lead us to believe that there will also be be a fair amount of disparity in the performance of the markets.
Another factor affecting the markets is inflation. This has been a problem in Asia over the last couple of years as commodity prices have been rising. Yet the problems in Europe have reversed commodity inflation and slowed Asian economic growth which has mitigated the inflationary problems in Asia and has given some governments the leeway to lower interest rates. All of this is very positive for the equity markets, which have begun to respond very positively.
The last factor is the Asian economies’ ability to grow when the major economies elsewhere in the world are growing very slowly. This is of particular concern since these economies are very dependent on exports. Certainly Asian governments are aware of this problem and have begun to adjust their policies to move their economies to be more dependent on local consumer demand. But this is a slow process and may take several years to evolve.
Putting all of that together, we think that the lower interest rates and the momentum of the markets from the fourth quarter will carry the day and the Asian markets will have a good year.
Putting Europe and Asia together and looking at non-U.S. stocks as a whole relative to the U.S. markets is difficult because there are so many individual markets that make up the whole. However we believe 2012 will be a reasonably good year for the international markets and certainly an investment worthy of its position as a diversifier in most investors’ equity holdings.