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September 25, 2014

US, Europe or Emerging Markets?

The US equity market has significantly outperformed other regional markets over the last few years. Investors should not chase past performance. The key metrics to base your investment decision on should be valuation, since there has been historically a close relationship between entry level valuation and future performance. Put simply, good things happen to cheap asssets while expensive assets tend to exhibit below-average future performance. Where do we stand today? Research by Research Affiliates (>$150bn assets under management) has shown that US equity markets now trade above historical trends while European and Emerging markets trade either in-line or even below historical averages.

The US equity market is trading on 25x average earnings while Emerging Markets and Europe trade on 15-16x average earnings (based on S&P 500, MSCI Emerging Markets and MSCI EAFE Index). This calculation uses the valuation methodology of Robert Shiller, a Nobel-prize winning economist. The so-called Shiller PE uses a price earnings ratio that is based on average inflation-adjusted earnings from the previous 10 years to smooth out any cyclicality.

Shiller US EAFE EM
Quelle: Research Affiliates

High valuation tends to lead to poor future returns while cheap valuation typically leads to strong future returns. The following table shows how the starting valuation has driven the future median annualized 5 year returns. As you would have expected, the higher the starting Shiller PE range, the lower the future returns in nearly every single case. This is the reason why Ipanema Capital uses valuation as its key asset allocation tool.

Return matrix English
Quelle: Research Affiliates

The counterargument we often hear is that Europe is mired in a recession and should be avoided. This line of thinking is making the common mistake of focusing on the newsflow and not on the valuation. Valuation tends to mean-revert. Also, most European companies are operating globally (e.g. BMW, Sanofi, Glaxo, Nestle) and thus also benefit from stronger growth abroad. Finally, there are solid arguments that Europe is starting to turn the corner (albeit slowly):

  • Weak Euro helps exporters
  • European banks have been big outperformers recently (end of deleveraging close, bank funding costs keep improving, NPL falling, improving lending conditions point to a stabilisation in loan growth)
  • EU earnings below trend (while US way above trend)
  • Flow-of-funds has been negative for Europe for the last few weeks (capitulation?)

It is very fashionable these days to compare Europe to Japan. All the pessimism is understandable but amidst all the doom & gloom it is worth highlighting that in the last quarter, for the first time since 2007, credit standards by EU banks have actually EASED on a net basis. The tide is slowly turning.

Will things be different this time? We doubt it and invest accordingly.

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