Global stocks are in bear market territory but some regions remain much cheaper than others. If you’re a value investor with a long-term outlook, you might be wondering: what’s cheap and what’s not? Is this a good time to be vacuuming up stocks?
"Periods of panic generally open up lucrative buying opportunities," says German investment firm Star Capital. It notes that, in the past, contrarian investors who bought after the S&P 500 fell 30 per cent were rewarded with average high returns of 20, 65 and 189 per cent over the next one-, five- and 10-year periods. Pandemics were no exception; stocks fell less than 25 per cent during the two pandemics of the last century – the Spanish flu in 1928 and the Asian flu in 1956 – before going on to enjoy above-average returns in the following years.
That said, crises are not always buying opportunities for investors; long-term returns were poor in the aftermath of the 1929 and 2000 market crashes, both periods associated with extremely high valuations and large earnings declines.
Additionally, Star Capital’s data shows that, in crises, the S&P 500’s cyclically-adjusted price-earnings ratio, or Cape, has historically fallen to an average of 12 – roughly half today’s levels.
Cape ratio
The Cape ratio has its critics, and many say US indices will not fall to similarly low levels today due to structural market changes over the last three decades. However, supporters argue the Cape ratio is invaluable in determining whether stocks are overvalued and undervalued.
Right now, analysts agree that earnings will plunge, but they have been slow to update their forecasts as they have little idea as to how far they will fall or for how long. As a result, one-year price-earnings ratios based on trailing or forward earnings are of little if any use in assessing the valuation picture.
In contrast, the Cape averages earnings over a 10-year period, smoothing out the highs and lows of the economic cycle. It's at times like now, when earnings are about to get "decimated", that the Cape ratio "shines", says Callum Thomas of TopDownCharts.
Following past market crashes, it has taken an average of four years for old market highs to be permanently exceeded, according to Star Capital data. US investors may need to be especially patient, it cautions, given that the S&P 500’s current Cape ratio remains roughly 25 per cent above historical norms and twice as high as that seen in crisis periods.
Against that, it should be noted that US Cape ratios have risen steeply in recent decades. Indeed, JPMorgan’s latest Quarterly Guide to the Markets shows that the S&P 500 has traded on an average Cape ratio of 27.7 over the last 25 years, indicating that US stocks may be slightly undervalued today.
Nevertheless, value investors should be looking outside the US, says Star Capital. Whereas the S&P 500’s Cape is nowhere near its 2009 low (13), some stock markets such as Britain, Spain, Norway, South Korea, Singapore and numerous emerging markets are “already trading close to or below these crisis valuations”.
In recent decades, the firm says, there have “rarely been opportunities to buy stocks at such low prices”.
Emerging markets
This excitement is shared by Callum Thomas, who says medium- and long-term investors will be “mentally salivating” if stocks fall back to near their March lows. At that point, almost 70 per cent of national stock markets were trading on cheap valuations.
Emerging markets’ Cape ratio dropped “all the way back to 2003 levels”, surpassing the lows seen during the 2008-2009 global financial crisis. Developed markets outside the US also “almost broke to a new all-time low”.
Thomas is less excited by the US. There, the Cape remains “materially higher relative to the 2009 low”, although the US picture looks somewhat better if one uses a blended measure that combines other valuation metrics, with the S&P 500 going from “significantly expensive to slightly cheap”.
Research Affiliates, the firm founded by value investor and smart-beta pioneer Rob Arnott, has a similar take. US stocks don't look attractive relative to US history or to other markets.
In 2016, Arnott said emerging markets represented the “trade of the decade” – a call that appeared prescient as emerging markets stocks roared higher over the next two years, but they have since come back down to earth and are now looking very cheap.
How cheap? Current pricing suggests emerging market equities are poised to deliver annualised real returns of 8.5 per cent over the next decade, estimates Research Affiliates. European stocks are also “starting to look a lot more attractive than US equities”, while British stocks look even better; cheap prior to the coronavirus crisis due to Brexit risks, they “are a bargain today” and should slightly outperform even emerging market equities with a “much lower level of risk”.
However, investors can do even better if they plump for the cheapest value stocks in emerging markets, which should deliver annualised double-digit percentage returns (after inflation) over the next decade.
The case for emerging markets is also advanced by the Institute of International Finance (IIF), a global association of financial institutions. Trading on a Cape ratio of just 7.8, emerging market equities have now dropped to a record 65 per cent discount to US stocks.
This level of valuation "gets me excited", says James Montier of GMO, the fund founded by renowned value investor Jeremy Grantham. Like Research Affiliates, Montier is particularly excited by value stocks in emerging markets, which he estimates are priced to generate real returns of almost 14 per cent annually over the next seven years.
Caution
However, not everyone is pounding the table for emerging markets. JPMorgan says emerging market stocks trade on 1.38 times their book value (the firm's preferred measure for valuing emerging market stocks), which is still above the lows set during the global financial crisis (1.17) and the 1998 Asian financial crisis (0.9).
The IIF cautions that, while emerging market valuations look “compelling” from a long-term perspective, concerns about growth, commodity prices, sovereign debt distress and the health threat posed by the virus “will weigh on risk appetite”. In other words, cheap stocks can get cheaper – something that will be recognised by anyone who has lived through a bear market environment.
This point is conceded by Montier, who admits that “buying when cheap is no guarantee of immediately higher returns”. Nevertheless, crisis can get bring opportunity, with Montier saying that it “does bode well for good long-term returns” – a viewpoint that seems to be the consensus among contrarians and value investors right now.
