Stocks Valuation: A Debate

Nir Kaissar and I had an interesting discussion/debate about the valuation here: How to Know When Stocks Are Properly Valued: A Debate

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With U.S. stocks reaching new records almost daily, there’s an endless discussion about whether equities are cheap or expensive. Bloomberg Gadfly columnist Nir Kaissar and Bloomberg View columnist Barry Ritholtz met online to debate the valuation question.

Kaissar: Everyone knows that U.S. stocks look expensive relative to the rest of the world. The Standard & Poor’s 500 Index has outpaced both the MSCI EAFE Index — a collection of developed market stocks outside the U.S. — and the MSCI Emerging Markets Index by 6 percentage points annually since March 2009, when the market hit bottom, through May, including dividends.

Valuation aficionados love to argue about which yardstick is best — price-to-earnings ratio, price-to-book or price-to-cash flow. But this time there’s no argument. All three measures point to higher stock prices in the U.S.

Ritholtz: I look at equity valuations from a different perspective. There are three things investors should take note of:

1. “Fair value” is simply a point that stocks careen past on their way to being either cheap or expensive.
2. Valuation cycles are driven by psychology; during bull markets, investors become willing to pay more and more for a dollar of earnings; bear markets see the opposite.
3. Eventually, mean reversion reasserts itself and the regional performance gap between the U.S. and Europe will reverse.

Of course, getting the timing of this right is very, very tricky. One last thing to keep in mind: the U.S. has been trading at a premium over the MSCI EAFE and MSCI EM indexes for a few years — more often than not, the markets see good reasons for those higher valuations.

Kaissar: I agree that valuations are cyclical. But whether those cycles are driven by behavior — or in Barry’s parlance, psychology — or risk is a critical distinction.

The view favored by buy-and-hold investors is that low valuations reflect higher risk, so there’s no free lunch (or alpha, in geek speak) available from buying cheap assets. On the other hand, if valuations reflect only the mood of investors, the implication is that value and risk can decouple and that investors may be able to exploit that decoupling.

I tend to favor the behavioral explanation in this context, and I think the current environment is a good example. The price-to-book ratio of the S&P 500 is now twice as high as that of EAFE and EM. Can we credibly say that the U.S. is half as risky as those other regions given the U.S.’s multiyear struggle to kick-start its economy and its recent political turmoil? I don’t think so.

Now the harder question is whether investors can exploit these valuation gaps.

Ritholtz: Let’s make sure we are all using the same definition of risk: I define risk as the probability that actual returns on an investment will be lower than the expected returns. Not volatility, drawdowns or losses, but less-than-expected returns. What expected returns should long-term equity investors reasonably anticipate? About 10 percent with dividends reinvested, which is what an S&P 500 total return fund generated from 1990 to present — 10.04 percent to be exact. Where valuation comes into this is periods when stocks are expensive; your expected returns should go down proportionately. Similarly, when stocks are cheap, your expected returns are likely to be higher. However, that is just the average — there are years where expensive stocks saw double-digit appreciation (the 1990s) and years where cheap stocks did very poorly (the 1970s). It is a complex and often nonlinear relationship. Hence, the perception of risk is certainly a psychological element, one that can manifest itself in investor behavior of buying or selling.

Kaissar: I’m not quite ready to dismiss volatility and drawdowns as barometers of risk. Investors are more likely to abandon high-volatility or high-drawdown assets at the wrong time than ones with lower volatility and drawdown. So it’s worth considering how an investment is likely to behave.

Volatility and drawdowns have another virtue, too: They’re measurable. For example, the earnings yield for the S&P 500 is 4 percent and the yield for EAFE is 6.3 percent (using 10-year trailing average positive earnings). Let’s assume for the sake of argument that the earnings yield is a good proxy for expected return.

One can test whether higher earnings yields have been associated with higher volatility or larger drawdowns. Granted, historical data is never dispositive, but it can be instructive. If you conclude that EAFE’s higher earnings yield means a bumpier ride, then there’s no reason to prefer EAFE over the S&P 500 on a risk-adjusted basis. If you don’t, then EAFE may be the better bet.

But however one defines it, risk in this context is simply a vehicle for answering the broader question: Namely, should investors prefer EAFE because it has a higher expected return than the S&P 500?

Ritholtz: It’s an old joke to say that not everything that matters can be measured, and not everything that can be measured matters. Back to EAFE versus EM versus the U.S.: The thing is, you don’t have to pick one over the other. You can (and should) have exposure to all of these various asset classes. But first, let’s acknowledge the elephant in the room, namely valuations: Based on the relative expense of U.S. stocks when compared with other developed and emerging markets, the U.S. markets are quite pricey. Value investors are advocating a shift away from the U.S. and into these other regions. But here’s the thing: The pundits were making these exact same suggestions three, four and five years ago. Had you followed their advice then, you bought into “submerging” markets and a European mess, while the U.S. still had lots of upside to go. The evidence suggests to me that rather than timing which part of the world is going to do better or worse, it’s better to own it all. The alternative is playing a guessing game that history suggests few, if any, are especially good at.

Kaissar: You raise two points that are worth unpacking separately.

Originally: How to Know When Stocks Are Properly Valued: A Debate