When you put together price appreciation with growth in corporate profits for different global markets, you get some interesting, even surprising, conclusions.

The table below sums the results.  A positive number (“Rerating”) means price appreciation has exceeded growth in corporate profits, perhaps suggesting that the market is now valued more expensively.  Conversely, a negative number (“Derating”) means price appreciation has lagged growth in corporate profits, implying the market is valued more cheaply than prior to 2008.

Note: ETF’s used to calculate total return from 12/31/2007 to 9/20/2018.  Total return includes price performance and dividends in US Dollar terms.

ETF’s used included EEM (Emerging Markets), EWJ (Japan), SPY (US), EZU (Europe ex-US), and EWU (United Kingdom).  These are suggested proxies for the underlying equity markets and not indicative on any recommendation.

Source: ycharts.com, MSCI, T. Rowe Price, iShares, and Ambassador Wealth estimates. 

USA Is Number One, But Will It Stay That Way?

The US has been the valedictorian over this decade when it comes to robust corporate earnings growth.

However, the US market has also experienced price appreciation far greater than growth in earnings.  Potentially, that might be a red flag for the market.  (However, we would argue that it reflects more on specific parts of the market, such as certain high-flying technology stocks, rather than necessarily a wholesale indictment of the US market overall.)

Japan Might Be Cheap If Corporate Profits Hold Up

Japan reflects moderate undervaluation relative to earnings.  As discussed earlier, Japan faces investor skepticism to the durability of its earnings recovery.  Yet, if and as earnings continue to grow, the market might have potential to rerate, or at least hold its own in the event global markets were to sell off.

Emerging Markets – Glass Half Empty or Full?

In spite of their poor performance over the last decade, Emerging Markets appear quite fairly-valued (not expensive, neither cheap) given where earnings stand.  A resumption in earnings growth could help the asset class.

Biggest Losers Are Europe With or Without the UK

Europe and the UK surprisingly look overvalued relative to earnings.  Indeed, on this measure, the UK is the most expensive market in the world based on markets outperforming the decline in corporate earnings.  This is even worse than the US.  Unlike the US, neither the UK nor Europe boasts large high-growth, high-valuation technology companies.  Europe and the UK are simply victims of poor earnings.

It would take a significant recovery in corporate profits just to work off the overvaluation in these markets to bring them back to fair value.  That does not rule out occasional fits and short-term rallies.  However, it appears difficult for Europe to post a meaningful bull market for the time being.

We also dare not neglect the macro risks surrounding Brexit and the Euro.  Europe might be swimming upstream for a while.

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What actually happened over the last decade?  Take a look.

Note: ETF’s used to calculate total return from 12/31/2007 to 9/20/2018. Total return includes price performance and dividends in US Dollar terms.
ETF’s used included EEM (Emerging Markets), EWJ (Japan), SPY (US), EZU (Europe ex-US), and EWU (United Kingdom). These are suggested proxies for the underlying equity markets and not indicative on any recommendation.
Source: ycharts.com, iShares, and Ambassador Wealth estimates. 

USA Dominates the World

What stands out is the performance of US stocks.  Over the last decade (including the bear market of 2008), US stocks have done well.  US stocks have yielded a cumulative return of nearly 150% over the last 10 years.  On an annualized basis, the US has returned roughly 9% per year.  Not only is that a decent return, but it places US stocks as the top region in the world over the last decade.

Some of the strong return performance of the US relative to ROW (“Rest of the World”) stems from superior corporate earnings performance.  However, as we shall see in the next section, corporate earnings do not explain the total picture.

Europe and Emerging Markets Have Been Dull

In contrast, international markets have been relative losers.  Emerging Markets, the UK, and Europe ex-UK have been practically flat over the last decade!

In the case of Europe and the UK, further declines in corporate earnings since 2008 have been a major culprit.  Lower earnings compel investors less excited about paying much for them.  Both Europe and the UK have heavy exposure to banks, which have seen dramatic earnings downgrades due to a host of issues, including low-interest rates and much stricter capital requirements following the Global Financial Crisis.  Other regulated industries such as utilities and telecom have also suffered huge earnings declines.  There are very few high-growth technology companies in European indices.  Hence, the European markets have performed quite badly this decade.

Emerging Markets is more of a mixed bag.  While performance has been similar to that of Europe and the UK, Emerging Market companies are sporting better earnings.  Earnings have been more volatile and below their historic highs.  Additionally, markets have questioned the quality of those earnings, given Chinese state-owned companies are a major part of Emerging Markets.  Macro concerns about the impact of higher US interest rates on Emerging Markets, trade wars, and rising political risks in major countries have also been more of an overhang for investors than the attractiveness of specific companies.

Could the Sun Keep Rising in Japan?

Japan is also an interesting case.  In spite of robust earnings that rival those of the US, returns have been only slightly better than its international peers.  Part of it stems from skepticism on earnings in light of significant demographic challenges in the country (aging population, mature economy) and how much monetary policy has inflated earnings.  On the flip side, Japanese companies have expanded their international operations, improved corporate governance, and funded higher dividends and share buybacks with cash, not debt like in the US.

Putting earnings and market performance together yields some interesting results.  Read the next installment for some surprising conclusions.

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Our asset allocation has favored the United States and Japan at the expense of Europe and Emerging Markets.  A long-term perspective on corporate profits and valuation might still justify this stance.  Let’s see how.

The Science and Art of Valuing Investments

How do you value an investment?  While there is a bit of “art” to defining that, we can still apply some “science” to get us closer to the answer.

One simple way is to look at the annual profit the investment is expected to produce.  Then figure out how much you are willing to pay for it.  Whether it be equities, real estate, or an oil well, you typically would expect to pay some multiple (several years equivalent) on that one year’s worth of profit.

If you look at this ratio as valuation divided by profit, you have what many call a “Price to Earnings” ratio.  There are other ways to describe this ratio (for instance, capitalization rates in real estate where you take the reciprocal, e.g. profit/cash flow divided by valuation paid, and expressed as a percentage).

For the purposes of this exercise, we will use the “Price to Earnings” approach.

Let’s look at profits prior to the last (and quite severe) bear market of 2008.

Earnings Recovery Strong in US and Japan, Weak in Europe, Tepid in Emerging Markets

The chart below shows earnings compiled by MSCI for 5 major regional stock markets around the world: Emerging Markets, Japan, the United States, Europe (Excluding the United Kingdom), and the UK.  The chart looks backward at what earnings were in the year 2008 (known as “the Global Financial Crisis”).  Each regional market’s earnings are indexed to the number “100”.

The chart then examines what happened to earnings every year up to 2018.  We particularly want to focus on the years 2008 and 2018 for this analysis.  2008 is the start of our analysis (arguably a “high” level of earnings prior to the bear market and economic recession).  2018 reflects where earnings are right now.

If a line for the year 2018 is above 100, that means earnings today for a given regional market are above their level back in the prior cyclical peak of 2008.  Companies in that market are making more money than a decade ago.

However, if a line in 2018 is below 100, that means earnings today are still below levels of 2008.

What can we learn about earnings in each of these major regions of the world?

Source: T. Rowe Price, MSCI, and Ambassador Wealth estimates.

Earnings are at historical highs in these markets:

• Japan
• United States

Earnings are better than 2008 now, but they are below prior historical peaks (and those of other strong markets):

• Emerging Markets

Earnings are below (indeed, substantially below) levels of 2008:

• Europe ex UK
• UK

In a future blog, we will discuss some of the reasons and potential future implications for the direction of earnings and valuations.

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