For managers who have portfolios invested in multiple markets, we provide research to help them determine which markets will outperform.
Whenever we have to decide whether to overweight or underweight a market, we have to decide whether one market will perform better than the other. Why then do fund managers make such decisions relying only on information of individual markets without a tool to compare one against the other? Why then do fund managers focus on the macro aspects of the market when a market is actually comprised of individual companies?
We believe that in order to determine whether one market will do better than the other, we need a mathematical tool to compare one with the other. And we need to use bottom-up information from the stocks in the two markets because a market will only better than another if the stocks in that market do better than the stocks in the other.
There are only two reasons why one market outperforms another. For example, if we value the market using PE, Market A will outperform Market B (or a larger region) when PE Ratio of Market A divided by PE Ratio of Market B goes up OR earnings growth of Market A is higher than earnings growth of Market B.
The above reasoning would be true for the other market indicators such as Price to Sales, Price to Book, Price to Cash Flow and Dividend Yield.
Using the above methodology, we could determine whether the US market is likely to outperform world equities in the next few years. First, we looked at the valuation of the US market vs. the world based on Price to Earnings, Price to Sales, Price to Cash Flow and Price to Book. We see how this has changed over a long period starting from 1996, which covers the height of the dot-com bubble and depth of global financial crisis. We also determined what the average premium or discount to world market is and where we are at currently.
Secondly, we determined how the fundamentals of the US market (i.e. earnings, sales, cash flow, book value) are expected to grow vs. the world. We put all of this in graphical form and are able to give useful insights.
In order to gather information on world markets, we compiled information from 42 stock markets, which together account for 97% of the world’s market capitalization. The companies we gathered information from are component stocks of the major indices in the respective countries and together they number slightly more than 10,000 companies.
The first chart below shows that the US market traded at an average PE premium of 18% compared to world markets (see the red line) and is now trading at this average premium. The US market has outperformed world markets since 2010 not because of valuation rerating but due to superior earnings growth. Going forward, earnings growth in the US will be roughly the same as world earnings growth (see flat red line). Therefore, based on this graph, US equities are not expected to outperform world equities.
US market is trading at average Price to Sales premium to world equities of 48%. This declined significantly during 2008 and 2009 but the market is now trading back at its historical premium. Sales is growing at the same rate as the rest of the world so based on both relative valuation and sales growth, the US market is not expected to outperform the world market.
US equities are trading at its average Price to Sales premium of 34%. Cash flow of US stocks are growing slightly faster than the world so based on this chart, it points to slight outperformance of US equities vs. the world.
US stocks are trading above the average Price to Book premium of 47% and book value of US equities are growing at the same rate as the world. Therefore this chart points to underperformance of US equities vs. the world.
Since different indicators give us slightly different readings of the market, we rely on our proprietary Composite Model, which combines the different indicators in a way that best explains the relative performance of the market. This composite chart tells us that the US is trading at fair historical valuation vs. the world and fundamentals are expected to move flat relative to world fundamentals. This points to flat performance of US equities vs. the world.
This method of analysis can also be used to compare any two markets e.g. US with Europe, Asia, etc.
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