Episode #175: The Biggest Valuation Spread In 40 Years?
Guest: Episode #175 has no guest, It’s a Meb Short.
Date Recorded: 2/27/19
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Summary: Episode 175 is a Meb Short. In this episode, you’ll hear Meb discuss a key development to be aware of in global markets, the valuation spread between the most and least expensive markets around the world. Meb explains why it is important to study history before assuming the U.S. deserves a valuation premium to the rest of the world, what global equity valuations look like, and the reality of investor home-bias.
All this and more in episode 175.
Links from the Episode:
- 0:50 – Welcome
- 2:30 – The Biggest Valuation Spread in 40 Years? (Faber)
- 6:02 – Twitter allocation poll
- 6:42 – The Global Case for Strategic Asset Allocation and an Examination of Home Bias (Vanguard)
Transcript of Episode 175:
Welcome Message: Welcome to “The Meb Faber Show” where the focus is on helping you grow and preserve your wealth. Join us as we discuss the craft of investing and uncover new and profitable ideas all to help you grow wealthier and wiser. Better investing starts here.
Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
Meb: What’s up, podcast listeners. We have another “Meb Short.” And guess what, we’re gonna talk about something we never talked about before on the podcast, valuations. Just kidding. You guys got to be tired of this but I think this is a fun one. I think it’s important. Today’s podcast is called, “The Biggest Valuation Spread in 40 Years.” Earlier this week, I was in my local coffee shop. My favourite in Manhattan Beach is Two Guns. You may see me there in the mornings, maybe Pete’s. I love Pete’s. Lot more space. Anyway, ahead of me were two young moms chatting as their toddlers swirled around underfoot. I couldn’t help but notice as one of the moms nodding towards her child and told her friend, “You know, Billy is already doing some counting and spelling. He’s just so gifted.”
Now, the names have been changed to protect the innocent. If you live in L.A. or probably New York, you know this poor child has a random assortment of vowels and consonants mashed together to form a name the world has never seen before. He has to be unique. I can’t really talk, of course, but I didn’t get to choose my name. I love it though. Just don’t even ask me what my middle name is. So, as a father of a two-year-old, I glanced at Billy to size up the competition. He was licking the display window in front of the pastries. So, with all due respect to the mom, my money is on her perhaps being just a little bit biased.
In the investing world, many U.S. investors, commentators, financial media think that the U.S. is gifted. By this I mean they tend to believe that our stock market is the healthiest and most robust, therefore, it warrants a higher valuation than that of other stock markets around the globe. Is that true? Are we special? Or does the U.S. market lick the display glass just like everyone else? I’ll post this chart to the show notes, but as you can see as I write, as I discuss this, the U.S. trades in a long-term CAPE ratio of around 30. That level’s fairly high from a historical perspective. For further context, the CAPE average from countries around the globe is around 16 right now. That makes the U.S. level almost double the average country. Is that normal?
Many pundits will list the myriad reasons why the U.S. deserves this lofty valuation, the rule of law, gap earnings, stable government, haha. But take a quick look at history will cast doubt on the explanations. First, if the U.S. is truly special, it should always be special, right? Meaning if the U.S. market is so fantastic that a higher valuation is always warranted, then historically, it should always have a higher valuation. But that’s not what history tells us. If you look at a chart showing the U.S. CAPE versus the rest of the world, ex-U.S., this is just foreign stocks going back to 1980, which is we don’t have a whole lot of great valuation data before that, both have an average CAPE ratio of about 22. Let me repeat that. The historical valuation premium has been zero. Beyond that, the amount of time each spends being more expensive than the other is basically a coin flip. Sometimes U.S. stocks are more expensive, sometimes foreign stocks more expensive. That stat surprises a lot of people who assume that the U.S. being currently expensive always trades at a premium and for some reason deserves to. After all, the U.S. is special.
If you look at this chart, I will post to the show notes, you can see that foreign stocks were more expensive during most of the ’80s, and there’s a reason for that, whereas the U.S. has been more expensive during the internet bubble and, again, post-financial crisis. The reason that foreign stocks traded so much more expensive in the ’80s had a lot to do with Japan, had the biggest bubble we’ve ever seen. Again, not some backwater economy, still one of the largest economies in the world, the largest stock market in the world in the ’80s, had a CAPE ratio of almost 100 in the ’80s and dragged foreign stocks to be quite a bit more expensive than the U.S., which was cheap during most of the ’80s. How many of you all were buying stocks hand over foot when stocks were trading in the early ’80s and single digit CAPE ratios? Generational buying opportunity.
Today, however, marks one of the widest valuation spreads in history with foreign markets trading at much cheaper levels than that of the U.S. There was one other time when we had a massive valuation spread but it was the opposite. Foreign stocks were much more expensive in the ’80s, but in this case, the U.S. is. The spread only intensifies if we zero in on the cheapest quartile of countries around the globe. There’s about 45 investable countries around the world. So, if you look at the cheapest quartile, 25%, that means about 11, 12 countries, they’re trading a long-term CAPE ratio of about 11. That’s a whopping 62% lower than the U.S. or if you look at it the other way, it’s double, almost triple the cheap country valuation as the U.S. I pointed out in a post that we talked about on either prior or future podcast short, I don’t know if it’s been published yet, low CAPE values tend to lead to higher future returns 10 years later compared to the high starting CAPE values which tend to result in lower returns 10 years later.
As you examine your portfolio here beginning at 2019, how much you got in the U.S.? Given the historical context we just talked about, is your chosen allocation percentage warranted? I recently polled my Twitter followers, as I want to do, asking for their allocation to U.S. versus non-U.S. It turns out about 84% of people allocate more to the U.S. than to a basic passive index. That’s a pretty big active bet on valuations not mean-reverting. Are you really willing to make that bet? We like to call that a home country bias. If you’re a new listener of the podcast, you may not have heard me talk much about this. If you’re an old-time listener, you’re probably tired of listening to me talk about this. That’s where people put way too much into their own country’s stock market. Happens in every single country around the world. Has this same home country bias. Vanguard talks a lot about it. Every investor thinks their own country is special and allocates more than the passive index suggests. Happens in the U.S., happens in the U.K., happens in Japan, happens in Latin America, happens everywhere.
So, in a world where everyone thinks they’re special, it’s hard to be objective about something you’re emotionally connected to, which is why it’s so important to be asset class and location agnostic. As you look around the world with an eye of valuation, you better ask yourself, is the U.S. really that special or are you just licking the glass? Hope you enjoyed today’s very, very short podcast “Mebisode.” For graphs, we’ll post them to mebfaber.com/podcast. You can always find all the archives. Just grab a show on iTunes, any other place you find podcasts are sold. Some of the favourite apps: Breaker, Radio Public, etc. Thanks for listening, friends, and good investing.