Stocks around the world have rallied this year, supported by the broadest economic growth in a decade. This strong performance may leave investors wondering: Are stocks now too expensive?
“History says no, not necessarily,” says Jeff Kleintop, chief global investment strategist at Charles Schwab.
Current valuations can help in assessing potential market prices, as in theory an undervalued stock has more upside potential than an overvalued one. However, there has been no consistent relationship between global stock indexes’ price-to-earnings (PE) ratio—that is, price per share divided by the past 12 months of earnings per share—and stock market return during the following year, Jeff says.
For instance, Jeff says, the PE ratio for the MSCI World Index was recently 21.3.¹ Since the global stock index’s inception in 1969, when its PE has been in the range of plus or minus 0.5 point around 21.3 (that is, 20.8 to 21.8), total return during the subsequent 12 months has been anywhere between -5% to +45% during the subsequent 12 months. The average return has been +17.5%.²
“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,” Jeff says. “They could even produce double-digit gains, based on nearly 50 years of history, although of course history is no guarantee of future performance.”
Are some countries’ stocks too expensive relative to others?
U.S. stocks have posted double-digit gains so far this year. For instance, the S&P 500 Index is up more than 17% year-to-date as of November 28.³ Those gains have increased the valuation of U.S. stocks. As measured by the MSCI USA Index, the U.S. stock market recently had a PE ratio of 23, one of the highest ratios in the world.⁴ By comparison, the MSCI Euro Index had a PE of 18, and the MSCI Japan Index had a PE of 15.5
Should investors favor Japan over the U.S. and Europe because it has a lower PE? Again, not necessarily, Jeff says.
“We believe all three of these markets are fairly valued relative to how they perform,” Jeff says. “It’s important to look at the sectors that drive the performance of these markets.”
U.S. stocks, as a whole, have tended to behave similarly to the global information technology sector, Jeff says. Although the U.S. stock market is composed of only about 20% tech stocks, the MSCI USA Index nevertheless has demonstrated a significant correlation with the MSCI World Information Technology Index, in terms of valuation, Jeff says.
“In theory, the incredibly tight correlation of 0.99 between the two indexes shouldn’t exist,” Jeff says. “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.”
Meanwhile, European stocks tend to perform similarly to a combination of three different equity sectors: financials, telecommunication services and materials, Jeff says. Finally, the influence of financial conditions on all types of Japanese companies is evident in MSCI Japan Index performance, which tends to closely track that of the financials sector.
Relative valuations do not currently favor one country or region’s stock market over another, Jeff says. “Currently, these countries or regions do not appear materially over- or undervalued relative to the sectors they tend to 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.”
A case for global diversification
With stock markets valued fairly relative to how they perform, it’s a good time for investors to consider global diversification, Jeff says.
Stock correlation among major countries has fallen to the lowest levels since the mid-1990s6. Low correlation means the stocks of the various countries tend not to move in the same direction at the same time—in other words, when the stock of one country or region is rising, chances are good that stock of other countries will be moving in a different direction, which can enhance the benefits of diversification.
“From a diversification perspective, there hasn’t been a better time in 20 years to be globally diversified,” Jeff says.
¹Source: Charles Schwab, MSCI data as of 10/31/2017.
³Source: Bloomberg, as of 11/28/2017.
⁴MSCI USA Index data from Factset, as of 10/31/2017.
5MSCI Euro Index and MSCI Japan Index data from Factset, as of 10/31/2017.
6Based on average correlation (daily one-year rolling correlation of one-month percent change) in MSCI indexes for countries in the Group of 20 (G20) plus Spain. Source: Charles Schwab, Factset data as of 11/20/2017.
What you can do next
- Changing economic conditions can affect how each component of your portfolio performs. It’s impossible to predict which one will be the top performer in any given year—that’s why diversification is so important. Want to talk about your portfolio? Call our investment professionals at 800-355-2162.
- Watch Schwab experts discuss other market and economic topics in the Schwab Market Snapshot.