Global Market Valuations and Expected Returns - June 6, 2014

In January 2014, the stock market benchmark S&P 500 lost 3.36% after the excellent 2013. The enthusiasm went back as the market gained 4.31% over February. In March, it went up only 0.69%. In April, it was about even for the whole month. And in May, the market gained 2.10%. What is the situation in the other parts of the world? In April, the key indexes in Europe had positive return figures. Germany’s DAX index increased 3.54%. France’s CAC-40 index gained 0.72%. The FTSE 100 index went up 0.95%. Stock markets performances in Asia were strong. Japan’s NIKKEI 225 increased by 2.29%. Hong Kong’s Hang Seng Index surged 4.28% and China’s SSE Composite index was moderately up by 0.63%.

In Morgan Stanley Institutional Global Franchise Fund’s March 31, 2014 commentary, it said, “Emerging market exposure appears to have turned from a virtue to a vice, driven by a change in the global interest rate environment, disappointing expectations for China’s gross domestic product (GDP) growth and mounting political and fiscal concerns in Eastern Europe.

We expect more consumption and 'up-trading' of consumer staples products.

Have emerging market consumer staples become a source of value following recent market activity? No. We believe they remain expensive. The weighted average next 12 months (NTM) price-to-earnings (P/E) for emerging market equities as a whole is 15x, with a Price to Free Cash Flow (NTM) of 23x. By comparison, emerging market consumer staples stocks are trading at an elevated 22.5x P/E and 27x Price to Free Cash Flow. It seems emerging market investors are hiding in expensive emerging market consumer staples stocks, while global investors are betting on increasingly expensive industrials stocks.”

In Wasatch International Growth Fund’s March 31, 2014 commentary, it said, “During the quarter ended March 31, 2014, we saw European stocks do well driven by better sentiment toward Europe, the recovery of peripheral countries like Spain, and property markets like the one in the United Kingdom (U.K.) coming back, following a similar recovery to that of the U.S. The Japanese market had a very strong year in 2013 and we are not surprised there was a bit of a pull back at this point. Emerging markets have had a very rough period contending with just about every type of crisis, the main market anxiety being concern over China’s decelerating growth and deleveraging. The news and sentiment on emerging markets has clearly been poor across the board with issues ranging from slowing growth in Brazil to geopolitical turmoil in Ukraine. Our outlook remains constructive for the year given signs of bottoming in emerging markets and the ongoing recovery evident in Europe.”

In Causeway International Value Fund’s Semi-Annual Report, it said, “At the five year anniversary of the March 2009 equity market low, numerous indices fully regained or surpassed their pre-Global Financial Crisis levels. Benchmarks such as the S&P 500, MSCI World, FTSE All Share, and MSCI Europe ex-Eurozone indices, equal, or have surpassed prior peaks reached in 2006-2007. The key exceptions are Japan and the Eurozone, which respectively remain 33% and 28% below those highs. Although most indices have rebounded sharply, corporate profitability has not recovered by the same magnitude. Overall global profits of companies in the countries comprising the MSCI World Index are approximately 10% below where they stood pre-crisis and, excluding the US, they are 30% lower. These rising valuation multiples indicate investor optimism for equities over fixed income investments at a time when interest rates have likely exceeded their cyclical lows. Overall, developed markets equities already reflect considerable good news in terms of recovery in earnings. At present, many of the most undervalued stocks in the Fund’s portfolio typically share this “laggard” characteristic. Some of the largest potential returns should come from stocks in industries and sectors such as energy, banks, capital goods, chemicals and telecommunications. The underperformance of companies in the energy sector last calendar year coincided with sinking emerging markets. We believe that several of these energy-related stocks have upside potential. In addition, we continue to expect further improvement in profits of European banks, where we have already seen the cyclical peak for bad debts, regulatory restrictions and legal settlements. With banks in Europe and in the US, the next few years should bring 'write backs' of excess reserves, higher dividend payouts and share buybacks. We believe that certain banks could generate performance that compensates for their volatility and market risk.”

In Polaris Global Value Fund’s 1Q 2014 Report, Bernard Horn said, “With global markets up over the last two years, fewer companies are passing through our rigorous screening technology. Presently, the sectors most prominent in our screens include financials, industrials, consumer discretionary and information technology. The geographies at the top of our list include Japan, U.S., select Asian countries and the U.K. We have also noticed an increasing number of small and mid-sized companies in both developed and emerging markets; as these companies increase in size, the investable market will increase.”

In Wintergreen Fund’s 2013 Annual Report, it said, “Although we currently believe that having significant exposure to the growing markets of the world should lead to outsized returns over time, that was not case in 2013. Global markets were led by rallies in the U.S. and Japan in 2013, two markets where the Fund has been (and remains) underweight. Outside of the U.S. and Japan, many global markets did little in 2013. Our lack of Japanese exposure and smaller U.S. exposure relative to most other mutual funds had been positive contributors to the Fund’s performance in past years, but this trend has reversed in recent time periods. Conversely, the Fund’s significant weighting in companies with exposure to emerging markets which had driven past performance has proven to be a drag on recent returns. We will remain consistent in our approach and not let ourselves be tempted to think we can time the market and trade our way to riches. We continue to believe that while the U.S. has a bright future, the opportunities are far more appealing beyond its shorelines.”

In IVA Funds Annual Report, Charles de Vaulx and Chuck de Lardemelle mentioned, “Even though we argued over the past year that equities would probably be the best house in a bad neighborhood, we have not been fully invested in equities and, in fact, we have reduced our allocation to equities and simultaneously raised our cash levels as the year progressed.

Europe remains difficult for us. The eurozone economics are witnessing some degree of stability but many weaknesses remain (worsening public debt, costly credit, vulnerable banks...).

We have had almost no direct investments in the BRIC countries (Brazil, Russia, India and China) in recent time. However, we made our first investment in Brazil over the period; we also added a few names listed in Hong Kong doing business exclusively in China. But these markets are not cheap enough for us to make large commitments. In China, in particular, we worry about massive misallocation of capital and a potentially moribund banking sector.”

We reviewed the U.S. market valuations and the expected return and found that the U.S. market is expected to return 1.0% to 2.2% a year in the upcoming years. The global market provides a totally different picture. The returns in some countries show as being much higher.

The details of how to estimate the future market returns of the global market, the data sources and the interpretation of data have all been discussed in great detail in our new page: Global Market Valuations. Please go to that page if you want to learn more and have unanswered questions.

Please note that there are large errors in predicting the future returns of the emerging market because not enough historical data is available. These countries may not be able to grow at the same rate as they did before. But in general, the chance of having better future returns is higher for these markets that are traded below historical means than for those that are traded above.

As of June 6, 2014, the expected returns for the global market are shown in the chart below:

Among developed countries, Singapore has the highest expected market returns, which is 17.0%. Australia sits in second place. Spain ranks in third place with an annualized return of 10.6%. The expected returns are in the order of mid-teens a year. Among developing countries, the Chinese market is still the highest. The expected return is in the order of 36.4% a year.

These are the details of the expected return for the world’s largest markets:

Three factors decide the expected returns of the market. They are: economic growth, dividend payment and the current market valuations. If the current market valuation is below its historical mean, the contribution from the reversion of the market valuation to the mean is positive. Otherwise, it is negative.

Among developed countries, contributions from reversion to the mean for Sweden, Canada, UK, Switzerland, U.S. and Germany markets are negative because the stock markets in these countries are traded above historical means. For developing countries, Indonesia and Mexico are negative. The details can be seen in the chart below:

For detailed information and data interpretation, go to the page of Global Market Valuations.

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