Let’s pretend you’re a billionaire who wants to buy a few NHL hockey teams: The first team has won the Stanley Cup several years in a row. Most of the players on the winning team, however, are getting old. They’re slowing down, not checking as hard and their salaries keep increasing.
Several other teams, however, sell at bargain levels. One young team in particular gets faster every year. The Stanley Cup champions fear this team’s speed, checking ability and organized plays that put pucks into nets.
The first team represents the U.S. stock market: a group of aging players with sky-high salaries. The cyclically adjusted price-to-earnings (CAPE) ratio – which compares stocks’ current prices with their average annual earnings over the past 10 years – provides the most accurate assessment of future returns. When a country’s stock market trades far above its historical CAPE ratio, this usually signals a weak decade ahead. When the CAPE ratio is far below a country’s historical average, it bodes well for performance over the next 10 years.
For example, in Larry Swedroe and Kevin Grogan’s book, Reducing The Risk of Black Swans, the authors explain that when CAPE ratios historically exceed 25 times earnings, U.S. stocks barely beat inflation over the next 10 years. In other words, based on today’s valuations, they’re skating on thin ice.
According to Barclay’s Investment Bank, as of April 30, U.S. stocks traded at an eye-bleeding 36.8 times earnings. That doesn’t mean U.S. stocks will go on an immediate winless streak. They might keep flying from now until 2025. But if they do, the odds will be even higher that they’ll lose more than they’ll win from 2025-31. Or, they could crash soon, then pose a slow recovery to 2031. The CAPE ratio doesn’t accurately predict how stocks will perform in any given year. But when measuring 10 years ahead, it’s an uncanny fortune teller.
In 2020, in light of the pandemic, the U.S. stock market’s performances surprised almost everyone. But further from the headlines, some far cheaper markets scored more goals.
According to JP Morgan Wealth Management, emerging markets gained 18.5 per cent in 2020 compared with 18.4 per cent for the S&P 500, when measured in U.S. dollars. Chinese, Taiwanese and South Korean stocks gained a whopping 40 per cent on average last year, also in U.S. dollars. Despite that surge, they’re still far cheaper than U.S. shares.
Barclay’s Investment Bank says China’s stock market traded at a CAPE ratio of just 19.5 times earnings at the beginning of May. Most of the time, when a stock (or a stock market) offers high business growth, that accompanies higher price-to-earnings (PE) multiples.
Think of a high-growth technology stock compared to a low-growth bank stock: Tech stocks typically sport higher PE ratios because investors have higher expectations. But when China trades at a CAPE ratio of 19.5 times earnings, that’s like Amazon.com Inc. or Apple Inc.’s stocks trading at lower multiples than Wells Fargo & Co. or Citigroup Inc.
To take advantage of this aberration, you could buy the iShares MSCI China ETF (MCHI-Q). It gained a whopping 27.78 per cent last year, beating the S&P 500 index by more than 9 per cent.
According to Siblis Research, the world’s three most expensive stock markets include the U.S., India and Japan. The three cheapest include Poland, Russia and Turkey. If you have an iron stomach and a Buddha’s patience, you might want to bet on these bargains. Polish stocks trade at a CAPE ratio of about 10.9 times earnings. According to Morningstar, the iShares MSCI Poland ETF (EPOL-A) is priced cheaper today than it was 10 years ago.
Russian stocks also trade at bargain levels, with a CAPE ratio of about 10 times earnings. The iShares MSCI Russia (ERUS-A) includes Russian stocks and its dividend yield exceeds 4 per cent. Turkey rounds out the lowest priced market with a CAPE ratio of just 7.83 times earnings. The iShares MSCI Turkey ETF (TUR-Q) tracks Turkish shares, which are also cheaper today than they were a decade ago.
All three of these ETFs could beat the U.S. stock market index over the next 10 years, but few investors will likely have courage enough to wait. If these bargain ETFs don’t perform well over the next five or six years, even battle-worn contrarians might toss in the towel. That’s one of the things that make investing so darn tough: We seek immediate results, often at the expense of long-term gains.
Building a globally diversified portfolio of ETFs, however, is easier on the nerves. While doing so, you would have exposure to the world’s stock markets. When one market falters, another one could soar. That’s why it’s best to own them all. If, however, you still want to roll the dice, don’t double down on U.S. stocks now. Consider what’s on sale, instead.