Keep an Eye on Starting Valuations

By Chris Lowe, Editor-at-Large on November 25, 2014


Source: Wikimedia

As we’ve been warning members of Bill’s family wealth advisory, Bonner & Partners Family Office, investors today are focused on the doctor, not the patient.

It has largely been the efforts of central banks and governments to revive a flagging economy that has moved markets, not real economic change.

This is certainly the case in Europe…

The Stoxx Europe 600 Index – which tracks large-, mid- and small-cap companies across the 18 countries in the euro zone – just hit a two-month high.

This comes hot on the heels of Mario Draghi’s promise that the ECB “must raise inflation” as soon as possible.

Draghi is telegraphing massive QE in Europe. Stock market investors there are responding by bidding up stocks.

It’s also the case in China…

Yesterday, Chinese stocks trading in Hong Kong rallied the most in a year after the People’s Bank of China governor Zhou Xiaochuan surprised the market by announcing the first interest rate cut since July 2012.

The cut – which lowers the one-year bank lending rate by 40 basis points to 5.6% – follows news that Chinese factory orders in October rose at their slowest pace since 2009… retail sales fell below expectations… and the economy is set to grow at its slowest pace since all the way back to 1990.

Zhou joins Draghi and Kuroda in the “stimulus or die” camp.

That doesn’t mean all markets are created equal. Although many of the major economies are the subject of central bank stimulus of one form or another, valuations vary hugely from market to market.

You can buy the Chinese stock market for less than seven times trailing 12-month earnings. It will cost you 20 times trailing 12-month earnings to buy the S&P 500. That’s a discount of 65%.

And on a Shiller P/E basis – which looks at the average of 10 years of inflation-adjusted earnings and is a better indicator of future returns – as of the end of last month, the Chinese market traded on a multiple of 17.2 versus a multiple of 27.2 for the S&P 500. That’s a discount of close to 37%.

That’s a big deal. As Mebane Faber of Cambria Investment Management points out, low starting Shiller P/Es produce MUCH stronger long-term returns than high starting Shiller P/Es.

According to Faber, adjusted for inflation, the US stock market has returned 5.8% a year going back to 1900. And starting Shiller P/Es ranged from 6 (1920) to 44 (1999).

If you group the roughly 11 decades into thirds, and average the best returning four decades, you see the effect of starting Shiller P/Es.

The best four decades saw 10.4% annualized GAINS and had an average starting Shiller P/E of 13.25.

The worst four decades saw 1.41% annualized LOSSES and had an average starting Shiller P/E of 24.5.

This looks at results of different starting valuations across time in the same market.

But a strategy of buying the stocks of the cheapest countries as ranked by the Shiller P/E, holding for a year and repeating would have returned between 15.9% and 17.6%, compounded annually, from 1980 to 2013.

The MSCI EAFE Index – which tracks the performance of 21 international developed markets outside the US and Canada – returned 9.6% over the same period.

Our advice: Make sure you diversify your stock market portfolio globally. Favor stock markets that are inexpensive relative to long-term earnings over stock markets that are expensive relative to long-term earnings.

If you have the discipline – and the stomach – to stick to this strategy, you’ll do well over time.

P.S. Don’t forget to claim your FREE hardcover copy of The New Empire of Debt. It provides invaluable insights into why debt-ridden nations – including the US – are bad bets for investors right now. Here’s that link again for details of our limited-time offer.

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