Relative Valuation Update – US vs EM, Europe, and Foreign Developed

Last fall, I detailed the correct way to frame relative valuations when comparing aggregated stock indices such as the MSCI USA Index and the MSCI ACWI ex-USA Index.  That post is very detailed, covering even the crucial currency aspect of relative performance between two foreign equity markets, and so it is worth reading in its entirety if you have not done so previously.

The purpose of this particular post is simply to update where things stand after a period of strong performance for almost all global equity markets, as well as accounting for the landmark corporate tax cut in the U.S., which is dramatically altering many forward earnings forecasts.

First of all, I wanted to compare the U.S. with emerging markets (EM), which has been the darling of foreign equity bulls, given its apparent low valuations.  Now, to be sure, emerging markets appear cheap on a CAPE basis, but one could argue that CAPE is a distorted tool for this comparison, given that emerging markets are a constantly changing asset class.  For example, whereas ten years ago EM was heavy in resource companies, it is now heavy in technology companies, the result of changes in the construction of the MSCI EM index, which is the emerging market gauge of choice for most financial professionals.

With that in mind, I compared the relative valuations of the MSCI USA Index and the MSCI Emerging Markets Index by normalizing the differences in sector weights between the two, and then recasting each index with the normalized aggregate P/E (price-to-earnings) ratio, both on a ‘trailing twelve months’ (TTM) basis, and on a ‘next twelve months’ (FWD or NTM) basis [Note – for each comparison, I initially re-weighted each index by excluding real estate, as P/E ratios are not necessarily useful for real estate analysis]:

While the U.S. valuations weighted at EM sector weights do not change all that much, the EM index’s TTM P/E rises almost a full five points, from 14.26 to 19.2.  When using the forward or next twelve months P/E, – which some experts argue is more useful, given the recent corporate tax overhaul in the U.S., – the index normalization results in the U.S. dropping a bit, from 16.6 to 16, and EM rising from 11.6 to 15.3, hardly a significant disparity. [Note – for this particular comparison, energy was excluded from the analysis due to lack of data for EM.]

The results are similar, though not as pronounced, when comparing the U.S. to other developed markets.  For example, when comparing MSCI USA with MSCI ACWI ex-USA, the TTM P/E spread narrows a few points, from around seven to a bit more than 4…

…and from a little more than three to 1.6 on a forward earnings basis:

Digging a little deeper reveals that much of the discount between foreign and U.S. stocks must reside in Asia and other pockets of the developed market universe other than Europe, as normalization reveals that European stocks, – far from being an obvious bargain, – now actually trade at a premium TTM valuation to U.S. stocks…

…and essentially trade in-line with U.S. shares on a forward earnings basis:


In sum, while U.S. stocks may currently be expensive, both developed and emerging foreign stocks may not be the obvious bargain many have been claiming, and that is before even factoring in the threat of a resurgent U.S. dollar.