The US stockmarket has been very expensive for a long time. Yet history suggests there’s no reason for this.
Here at MoneyWeek we’ve been pointing out for some time that the US stockmarket is rather expensive relative to its history. Our favourite measure is the cyclically adjusted price/earnings ratio (Cape). This compares the current price of a market with its average earnings over ten years. Using the average means that you get a fuller picture (earnings obviously fluctuate with the economic cycle, so taking a single year can be misleading). Today the Cape on the US market is higher than at almost any time other than the peak of the tech bubble, which was one of the biggest stockmarket bubbles in history.
Given that, we feel fairly comfortable describing the US market as expensive.
Some people have objections to the Cape. These objections range from issues around changing accounting standards to questions about how comparable today’s asset-light businesses are to yesterday’s factory-heavy businesses. But the reality is that it doesn’t matter which measure you use to look at the US market – they all suggest it is expensive to some degree or other. For example, the “Buffett” indicator (so-called because US investor Warren Buffett said it was his favourite valuation metric way back in 2001) divides the total market capitalisation of US stocks by US GDP. Above 100% and the market is expensive – it’s now about 140%.
Of course the US has been expensive for a while now. And because of that, investors try to find reasons why. The US is in some way special because of its intense focus on the tech sector, or because of its legal system, or because it’s the world’s biggest economy. Yet as Mebane Faber of Cambria Investment Management points out, history shows that the US is anything but unique.
Faber looked at the Cape on the US market versus the Cape on the rest of the world excluding the US. He found that, “going back to 1980, both have an average Cape ratio of about 22”. In other words, there is nothing special about the US. “The historical valuation premium has been zero.” For most of the 1980s, non-US stocks were a lot pricier than US ones (mainly due to Japan’s massive bubble). US stocks took over during the tech bubble, then fell behind again between that bubble bursting and the run-up to the 2008 crisis, before surging ahead since then.
If history is any guide (it’s not always), this suggests that US stocks are now more expensive, relative to the rest of the world, than they have been since at least 1980. Faber’s point to US investors is to make sure that they have at least some exposure to overseas markets – but for those of us in the UK, it’s a useful reminder that while US stocks are in bubble territory, there is plenty of value to be found elsewhere.