The last time U.S. stocks were priced this high, they sputtered for a decade, while emerging markets soared.FeelPic/Getty Images/iStockphoto
You’re walking along a path when a long-time ice cream seller pulls up on his mountain bike, unhitches his freezer and puts up a sign that reads: “Ice cream cones, $12 each.” A few seconds later, another long-time vendor sets up shop. Her price: $6 for the same-sized cone with the same choice of flavours. Not surprisingly, a line forms for the cheaper treats.
Strangely, investors rarely do the same.
Consider the choice between a higher-valuation U.S. stock ETF and a cheaper emerging-market stock ETF in today’s market. Most investors look at recent past returns, while ignoring the current price.
According to Dimensional Fund Advisors, the S&P 500 averaged a compound annual return of 15.98 per cent in Canadian dollars over the decade ending Dec. 31, 2019. That would have turned $10,000 into a whopping $44,038 after just 10 years. In contrast, emerging markets averaged 6.28 per cent over the same 10 years, turning $10,000 into just $18,387.
Sonny Wadera, an adviser with Manulife Securities, says piling money into recent winners “is often a big mistake.” He points to the period from 1990 to 1999, which he says was the last time U.S. stocks “trounced emerging-market shares.”
U.S. stocks averaged 20.38 per cent per year over that time, while emerging markets trailed by more than 7 per cent per year. But, as Mr. Wadera says, “evangelists for U.S. stocks, and only U.S. stocks, soon burned holes in their accounts.”
Over the following 10 years, from Jan. 1, 2000, to Dec. 31, 2009, a $10,000 investment in U.S. stocks dropped to $6,625. In contrast, a $10,000 investment in emerging-market shares soared to $18,922.
Sometimes, U.S. stocks win. Other times, emerging markets take the prize. It depends on what period you’re measuring.
It’s also worth noting that, over the long term, they’ve earned surprisingly similar gains. For example, between January 1988 and May 31, 2020, emerging markets saw an average return of 10.15 per cent per year, while the S&P 500 averaged 10.69 per cent.
While nobody can consistently predict how stocks will perform, economist Robert Shiller’s cyclically adjusted price-to-earnings ratio, commonly known as CAPE, has been a useful guide. The CAPE measures inflation-adjusted earnings over several years and compares those average earnings with current price levels.
“When the Shiller CAPE is lower, expected stock returns are higher,” according to Benjamin Felix, a portfolio manager at PWL Capital Inc.
He notes that the U.S. market is currently trading at a Shiller CAPE of just below 30, while emerging-market stocks are trading just below 14. U.S. stocks are trading at almost twice their long-term average level. Emerging-market stocks, in contrast, are more appropriately priced.
Shiller’s research shows that when a stock market is trading far above its historical average CAPE level, poor returns usually follow for the decade ahead. When stocks trade far below their average CAPE, it usually bodes well for the next 10 years.
It’s important to note, however, that Mr. Felix and Mr. Shiller aren’t talking about predicting next year’s performance. CAPE ratios have strong correlations with future decade-long returns, but they aren’t strong predictors of next year’s gains or losses. No reliable measurement can guess such things.
However, the last time U.S. stocks were priced this high, they sputtered for a decade, while emerging markets soared. That’s why emerging markets might be poised for another decade-long win.
Other price signals also look bad for U.S. stocks. America’s businesses have continued to increase their dividend cash payouts. That’s good, but because U.S. stock prices are skipping on mountain peaks, their dividend yields (dividend payouts compared to stock prices) are near 129-year lows.
As of early June, the Vanguard U.S. stock market ETF (VUN) had a barrel-scraping dividend yield of just 1.41 per cent. That’s as crazy as a $50 ice cream cone. Only four calendar years saw lower dividend yields: 1998, 1999, 2000 and 2001. Each year represented a high CAPE level and a lame decade ahead for U.S. stock returns.
Dividend yields are usually highest in developed-market shares, but today’s emerging-market yields put U.S. yields to shame. For example, the Vanguard FTSE Emerging Market ETF (VEE) sports a dividend yield of about 3 per cent. That’s more than twice the yield on a broad U.S. stock ETF.
This doesn’t mean you should pile everything into an emerging-market ETF and shun U.S. funds. Instead, it means investors should diversify. If your portfolio includes individual ETFs, set a target allocation for Canadian stocks, U.S. stocks, developed international stocks, emerging-market stocks and bonds. Then stick to the allocation, year after year. Ignore all forecasts and economic news.
If you’re adding money every month, buy what’s required to maintain your goal allocation. If, at the beginning of 2020, you had a globally diversified portfolio aligned with your goal allocation, then during March and April, you should have been adding money to your Canadian and emerging -market stock ETFs. During the COVID-19 market crash in March, these ETFs fell the most, which means they required the biggest boost.
I added money to Canadian stocks in March. In April and May, I added to my emerging-market ETF. No, I wasn’t trying to time the market. I was just maintaining my goal allocation.
If you’re investing in a diversified portfolio of individual ETFs, you might want to do the same. Just don’t be afraid of emerging markets now. They might represent the world’s best deal.