By Kostya Etus, CFA, Portfolio Manager CLS Investments
International markets are having a standout year and finally outperforming the U.S. market for the first time since the 2008 financial crisis — a long-overdue reversal. But, that shouldn’t be surprising since markets are cyclical in nature (see chart below). We know that the U.S. has been trading at historically high valuations, which are traditionally accompanied by below-average future returns. So, now the question becomes: Have international market valuations caught up?
First, the discussion of ‘international versus domestic’ has a very strong home bias to it. Does a Russian investor think about ‘international versus Russia’? Most likely not. It is important to remember there are many countries in the world with well-functioning markets and similar investment opportunities. So, a better question is: What countries are most attractive?
Second, yet another benefit of ETFs is the ability to invest in specific exposures. ETFs have countless potential benefits over mutual funds, but one that is sometimes overlooked is the ability to get more granular while still staying diversified. An example of this is single-country ETFs, through which investors can gain exposure to more than 40 countries.
Third, valuations can be measured in many ways, but here are some general rules of thumb.
- Compare to history: Looking at a current price multiple says nothing about the investment if investors are not able to compare it to its historic average. For example, the technology sector may currently trade at high multiples, but it generally has historically. So, comparing a current price-to-earnings of technology versus a lower multiple sector like staples would not make sense.
- Use several measures: Which of the most common multiples is better: price-to-sales (P/S), price-to-book (P/B), price-to-earnings (P/E), or price-to-cash-flow (P/CF)? Each has its positives and negatives, so it’s helpful to use a composite of all four to avoid biases.
- Relativity: Step one of an apples-to-apples comparison is to compare each data stream relative to a common benchmark (typically a broad market index).
- Z-score: Step two on an apples-to-apples comparison is to standardize the data by measuring the number of standard deviations from a historic average. This is known as a z-score.
- Consistent data: This may be the most important point. All data must come from the same source and have the same start date to ensure consistent results. The more data the better, but consistency is key.
Using these best-practices, current composite valuations (average of the four multiples) are shown below. The charts below are relative to the MSCI ACWI Index and use data dating back to 2001 to encompass a full market cycle. The yellow lines represent one standard deviation from the average. Clearly, developed international markets look attractive when compared to the U.S. market, while emerging markets are inching closer to fair value.
