I had the chance yesterday to be a guest on the Bloomberg Radio program Taking Stock, which was an awful lot of fun. The hosts, Pimm Fox and Carol Massar, are both smart and well informed, and the other guest, Kevin Divney, had some very interesting views and was a pleasure to bounce ideas off of.
One of the side conversations Pimm and I had off the air concerned why investors get so worked up about short-term data, and we went back and forth about what the appropriate stance should be. He made the analogy to eating at a restaurant and not caring if someone in the kitchen spilled the salt, while I thought about driving to a destination without having to note the color of every other car on the road.
The problem with developing a long-term focus is that you need to know what’s really important, to make sure you’re not missing anything material. To use my driving analogy, if I want to get from New York to Boston, I need a map of the major highways, which defines where I want to go, and I need traffic information to determine the best way to get there on those main roads. What matters is how fast cars are moving on average on different roads, not whether a vehicle in the other lane is red or green.
When we invest, the road map is asset allocation, which outlines the different options we have to get to our destination. Traffic information is akin to market valuation levels. If no one’s on the road, you can be pretty sure you’ll get where you’re going faster than on a fully loaded highway. If market valuation levels are pretty low, you don’t have a lot of competition for those returns; if market valuation levels are high, that road is pretty crowded.
Mind you, there are always reasons the road may be empty or prices low, and potholes or economic troubles could well ensure that you get to your destination more slowly, or even not at all. Nonetheless, when I’m headed down to New York, I do check the traffic levels on the highways to see if there’s a better route.
Looking at the markets today, using information from a recent Goldman Sachs publication, I see that the U.S. stock market is trading at a 31-percent premium to historical valuation levels, based on a five-year inflation-adjusted-earnings P/E ratio. On the same measure, the world as a whole is trading at a 13-percent discount. Europe is at a 13-percent discount, emerging markets are at a 26-percent discount, China is at a 32-percent discount, and Russia is at an amazing 59-percent discount. You can make a pretty good argument that the U.S. is the most crowded road here.
There is, of course, no assurance that currently cheap markets can’t get cheaper—potentially much cheaper. There’s also no assurance that expensive markets won’t continue to rise and get much more expensive. Indeed, that is exactly what we’ve seen with many of these markets recently.
There is no reliable way to forecast the market in the short term. Longer term, valuations are about the best tool at our disposal, and they do appear to have some predictive power. You can argue over the best way to measure valuations, but the fact that they matter is beyond dispute.
Despite what I’ve said about the U.S. economic recovery and the much brighter long-term prospects we have here, relatively, international markets will, at some point, become cheap enough to be compelling. Whether we’ve reached that point is a judgment call, but I think the gap is now large enough that most investors should be paying attention.
Here’s another way of looking at it: U.S. stocks are now trading at retail prices while many other markets are trading at wholesale. As a committed cheapskate, I have to admit I’m tempted by a discount, even though I know it may not pay off for a while.