Relative Equity Valuations, Diversification, and Creative Destruction

Fascination with the stock market has become a national obsession, not least because the financial well-being of the majority of Americans depends on a healthy equity market.  Investing in equities has become a hobby for some, a profession for many, and a necessity for all.  Given this importance of the stock market both to Americans and, really, to the rest of the world – the US equity market is by far the largest in the world; Credit Suisse estimates that the US weighting in the global equity market is more than six times that of the next largest country – it is understandable that so much attention should be given to it, and also that so many attempts should be made to discern its intrinsic value, or to determine its future path.

It is no secret that the US stock market ranks among the most highly-valued equity markets in the world.  According to Star Capital’s fantastic database of 66 countries, the US market is the third-most expensive stock market, as measured by its CAPE ratio.  The current CAPE value of about 28 is higher than just about any other period over the last 100 years, save the notorious market “bubbles” of 1929 and 2000:

Certainly, relative expensiveness of the US equity market might drop a bit depending on the chosen metric, but the overall story remains the same:  US stocks are currently expensive on a historical basis.

However, there are many reasons why current valuations may deserve not only to be elevated, but to remain so.  For one, in the modern era, the US economy has suffered only moderate economic downturns and has, for the most part, enjoyed an epoch of stable, if not always benign, inflation.  Additionally, frictions such as investment costs and taxeshave been reduced considerably.  Others contend that the US market, which is currently heavy in technology companies, is inherently different from the railroad- and industrial-centric markets of the past, the logic being that their global dominance and high profit margins warrant a higher mark-up.  These are all plausible explanations for why equity valuations have well above their long-term averages for most of the past 30-40 years.

Yet these explanations are insufficient, in my mind, as they are not necessarily unique to the modern American experience.  Inflation, for example, has been steadier in nations like Germany and Switzerland over the last 50 years than in the United States, and in many developed nations, taxes on investment income are lower, yet valuations in these nations still lag the US.  Certainly, in the internet age, investment costs are as low in Europe, for instance, as they are in the US.

Regarding technology and profit  margins, it is true that profits as a percentage of GDP are currently historically high in the US, but they are actually much higher in Japan, though cash-adjusted valuations there have not benefited from this materially [thanks to my friend @teasri for this chart]:

So, if domestic policies or economic trends do not fully explain the difference in equity valuations, perhaps examining the equity markets themselves will reveal more insight.

To perform this exercise, I took the MSCI index data for each of the nations that holds a place in the annual Credit Suisse Global Investment Returns Yearbook.  I wanted to see the following:

1) How concentrated the various equity markets are, both by top holdings and sector;

2) Market characteristics in terms of valuation, performance, volatility, and drawdowns

Here are the results:

Table 1:

Table 2:

[note:  duration in the table above refers to the length of the peak-to-trough drawdown]

As you can see from the Table 1, it is somewhat revealing that of the markets observed, only Japan and the United States have less than 20% of their respective market capitalization represented in the ten most valuable firms.  Furthermore, the top holding in each market is less than 10% of the total index in only seven of the twenty-one markets observed, while only two nations – France and Germany – have less than one-fifth of their markets represented by one sector.

The performance data reveal that extremely concentrated markets have yielded mixed results, with Austria and Ireland suffering a terrible decade, while Denmark and New Zealand fared pretty well.  These results are worth excluding, however, as the performance of those markets was tied to the fortunes of one sector, or, in a few instances, one or two companies.

Given that the world is still recovering from the global financial crisis of 2007-2009, it would make sense that less dynamic – and financial-heavy – markets such as Spain and the United Kingdom would trade at a discount to the United States, not least because financial stocks tend to be considerably more volatile than the broader market, and more heavily regulated, and so therefore less able to reward shareholders.  An example of this was in the aftermath of the financial crisis, when many banks in the UK were, for a period of time, denied permission to pay dividends to shareholders.

Conversely, in markets such as Switzerland and the Netherlands, low-volatility sectors such as consumer staples and health care dominate.  As a result, these markets suffer less volatility than other markets, and so it is no surprise that their valuations are considerably higher than others.

In reality, though, the are only two markets, the United States and Japan, that offer investors broad, less concentrated exposure to investors.  This is important, because, as Philosophical Economics explains:

“In the year 1950, the average front load on a mutual fund was 8%, with another 1% annual advisory fee added in.  Today, given the option of easy indexing, investors can get convenient, well-diversified exposure to many more stocks than would have been in a mutual fund in 1950, all for 0%.  This significant reduction in the cost of diversification warrants a reduction in the excess return that stocks are priced to deliver, particularly over safe assets like government securities that don’t need to be diversified.  Let’s suppose with all factors included, the elimination of historical diversification costs ends up being worth 2% per year in annual return.  Parity would then suggest that stocks should offer a 2% excess return over government bonds, not the historical 4%. Their valuations would have a basis to rise accordingly.

Now, to clarify.  My argument here is that the ability to broadly diversify equity exposure in a cost-effective manner reduces the excess return that equities need to offer in order to be competitive with safer asset classes.  In markets where such diversification is a ready option–for example, through low-cost indexing–valuations deserve to go higher. But that doesn’t mean that they actually will go higher.  Whether they actually will go higher is not determined by what “deserves” to happen, but by what buyers and sellers actually choose to do, what prices they agree to transact at.  They can agree to transact at whatever prices they want.”

Certainly, this explains why the United States and Japan deserve higher valuations.  But there is also a ready explanation for why the United States trades at a premium, while Japanese equities trade at a discount.

The reason for that, I believe, is that Japanese equities have lost investor confidence.  In the table above, it can be seen that Japanese equities took 14 years to grind lower in a bottoming process the likes of which the US hasn’t seen in a generation, and, for all that, another 14 years later, Japanese equities are still roughly half of their peak values from almost 30 years ago.

As my friend, Sam Lee, has written, valuation trends are less cycles and more epochs, and they are part fundamental and part behavioral.  The inherent benefits of diversification, combined with the momentum of recent success, will obviously warrant a premium valuation against less diversified and less successful markets.  In the latter instance, it can be said that equity markets are guilty until proven innocent.

This brings me to my final point.

In the markets surveyed above, there is a lack of dynamism in the markets.  The top holding in Finland in 2000 was Nokia, and, a 12-year bear market later, it is still Nokia.  Similarly, in Germany and Japan, the top firms today are more or less the same as the top firms during prior market tops in 2007 and 2000.  In the United States, by contrast, the bellwether index, the S&P 500, is constantly removing and adding components at such a pace that the average length of time a company spends in the index is only 18 years, down from 61 years in 1958:

[chart via]

Not only are constituents changing, but leadership is constantly changing, too:

[table and data via my friend, @dividendgrowth,] – to enlarge image, right click & “open image in new tab” 

It is telling that of the top 10 S&P 500 companies today in 2017, Facebook and Google/Alphabet were not public in 2000, while Microsoft,, Facebook, and Alphabet/Google were not public forty years ago.

We have all been told that past performance is no guarantee of future results, but investors in US equities have every reason to believe that as long as the dynamism of the US market remains intact, its future performance should not languish too much, either.

In sum, when you combine the inherent quality of US equities – liquidity, diversification, dynamism, along with positive trend and comparatively soft drawdowns – with benign economic data, it is no surprise that US equities would be the most highly valued in the world.  That is, of course, not the same as saying they will not decline in value, or that some other market will not supplant them in the future, as Japan did for a period of time in the 20th century.  However, value-conscious investors, while prudently looking abroad for possibly cheaper opportunities, should prepare themselves the discipline and fortitude that investing in foreign markets require, as the US stock market is unique and with no peer.

Disclosure:  The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Fortune Financial Advisors, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Fortune Financial Advisors, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.