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Are Stocks too Expensive?

Are Stocks too Expensive?

Key Points
  • Although world stock market valuations are above average, similar valuations have produced double-digit gains over the following 12 months during the past 50 years.

  • Relative valuations do not currently favor one country or region's stock market over another.

  • Valuations support a globally diversified portfolio offering the best diversification benefits in 20 years.

Stocks are up every month this year supported by the broadest economic growth in a decade. This is great news. But, have stocks already priced in all that good news? Is it too late to buy

Too expensive to buy?

History says no. While valuation is important to long-term returns, there has been no consistent relationship between the price-to-earnings (PE) ratio (the price per share divided by the last 12 months of earnings per share) and stock market return over the next year, as you can see in the random scatter of dots for stocks around the world in the MSCI World Index in the chart below.

Nothing to see here: PEs and returns over the next year

Earnings scatter plot

Source: Charles Schwab, MSCI World Index data from Factset as of 10/31/2017.

The current MSCI World Index PE ratio is 21.3. Since the inception of the MSCI World Index in 1969, a PE in the range of +/- 0.5 around 21.3 (20.8 to 21.8) has been followed by a total return of -5% to +45%, with an average return of +17.5%. Though valuations are above average—reflecting the better than average economic and earnings environment, there is no reason to believe stocks couldn’t go higher over the next year and even produce double-digit gains based on nearly 50 years of history, although of course history is no guarantee of future performance.

Are some markets expensive?

The global stock market may not be too expensive to rise, but what about the markets of different countries or regions—are some too expensive relative to others?
 
The U.S. has one of the highest PE ratios among countries or regions right now. Compared with the MSCI Euro Index, which tracks stocks in the 19 Eurozone countries, with a PE of 18, the U.S. looks pricey. Japan, at a PE of 15, looks like a real bargain. You can see the performance over the past decade and current PEs in the chart below.

Different performance, different valuations

MSCI US EZ JP

.Indexes measure cumulative total return in U.S. dollars since start of 2006. 
Source: Charles Schwab, MSCI data as of 10/31/2017.

Should investors favor Japan over the U.S. and Europe because it has a lower PE? We believe the answer is no, as all three of these markets are fairly valued relative to how they perform. We can see this when looking at the sectors that drive the performance of these markets.

The U.S. tends to behave like the global tech sector, as you can see in the chart below. So it isn't surprising that the MSCI USA Index is valued like the MSCI World Information Technology Index, with a similar PE of 25. Strictly speaking, the U.S. stock market is composed of only about 20% tech stocks. So, in theory, the incredibly tight correlation of 0.99 between those two blue lines shouldn’t exist. But, in reality, it does. A bottom up weighting of the PEs of the stocks that make up the U.S. index misses the point of how the U.S. stock market actually behaves, and therefore, is valued.

Major stock markets are valued similarly to the sectors that drive their performance

MSCI Indexes

Indexes measure cumulative total return in U.S. dollars since start of 2006. 
Source: Charles Schwab, MSCI data as of 10/31/2017.

The Eurozone is composed of 19 European countries and tends to perform like—and is valued just like—a combination of three different world sectors: financials, telecommunications and materials. The MSCI Euro Index behaves like a mixture of .41x MSCI World Financials Index; .34x MSCI World Materials Index and .33x MSCI World Telecommunications Index.  The weighted PE of those global sectors is 18, the same as the Euro index.
 
Let’s now look at Japan. The consumer discretionary sector is the largest sector of Japan’s stock market, which includes globally-recognized companies like Toyota and Sony. But the influence of financial conditions on all types of Japanese companies is evident in their performance which tracks the financial sector closely. Japan’s stock market is valued similarly to the MSCI World Financial Index at a PE of 15.
 
The takeaway from this comparison of countries and sectors is that the valuation differences between countries reflect how they perform and gives a very different investment conclusion from a simple comparison of the country PEs. Currently, these countries or regions do not appear materially over or undervalued relative to the sectors that they track. The sector PEs are all above average, but they are similarly valued relative to their 15 year histories. Each sector PE falls between 65% and 78% of that sector’s 15 year high.

All this suggests relative valuations do not currently favor one country or region's stock market over another when seeking value. We favor asset allocations across borders in line with their strategic weightings in U.S. and international stock markets which mirror the weights in the broad indexes.

Diversification offers best value in 20 years

With stock markets valued fairly relative to how they perform there is little reason not to be globally diversified. From a diversification perspective, there hasn’t been a better time in 20 years to be globally diversified. The trend in correlation among countries has fallen to the lowest levels since the mid-1990s, as you can see in the chart below. Many investors have never seen this low correlation before in their investing lifetimes.

Global stock market correlation lowest in 20 years

G20 correlation

*Daily one-year rolling correlation of one month percent change in MSCI indexes for countries in G20 and Spain. Source: Charles Schwab, Factset data as of 11/20/2017.

It’s not too late to buy. Valuations support a globally diversified portfolio offering the best diversification benefits in 20 years.

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Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

The MSCI World Index captures large and mid cap representation across 23 Developed Markets (DM) countries*. With 1,634 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

The MSCI World Financials Index is designed to capture the large and mid cap segments across 23 Developed Markets (DM) countries. All securities in the index are classified in the Financials sector as per the Global Industry Classification Standard (GICS®).

The MSCI World Information Technology Index is designed to capture the large and mid cap segments across 23 Developed Markets (DM) countries. All securities in the index are classified in the Information Technology sector as per the Global Industry Classification Standard (GICS®).

The MSCI World Materials Index is designed to capture the large and mid cap segments across 23 Developed Markets (DM) countries. All securities in the index are classified in the Materials sector as per the Global Industry Classification Standard (GICS®).

The MSCI World Telecommunication Services Index is designed to capture the large and mid cap segments across 23 Developed Markets (DM) countries*. All securities in the index are classified in the Telecommunication Services sector as per the Global Industry Classification Standard (GICS®).

The MSCI Euro Index captures large cap representation across the 10 Developed Markets (DM) countries in the EMU. With 124 constituents, the index covers approximately 70% of the free float-adjusted market capitalization of the EMU.

The MSCI USA Index is designed to measure the performance of the large and mid cap segments of the US market. With 622 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the US.

The MSCI Japan Index is designed to measure the performance of the large and mid cap segments of the Japanese markets. With 314 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Japan.

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