Do U.S. Stocks Merit Higher Valuations?
Meb Faber, the CIO of Cambria Investments, doesn't think so.
Investors in U.S. stocks have gained more than twice as much over the past decade as foreign-stock investors have--a 16% return for U.S. equity on an annualized basis over the past 10 years versus just 7% for non-U.S. names.
But Meb Faber, chief investment officer of Cambria Investments, believes that investors overweight U.S. stocks at their peril. In a recent episode of Morningstar's The Long View podcast, he argued that U.S. stock valuations are stretched, particularly among the largest names in the U.S. market. Meanwhile, non-U.S. names look significantly more attractive on a valuation basis. In this excerpt from our conversation, he discussed that thesis.
Christine Benz: You're a really strong believer in valuation as an input to the investment decisions that you make. And you've written extensively about areas that you believe are overvalued, the U.S. stock market in particular. How overvalued are U.S. stocks, in your opinion, and what's the basis for you making that assessment?
Meb Faber: Let's go back five decades. And this was before I was born, but there was a massive earthquake/nuclear bomb that went off in the asset-management industry. It went by the name of John Bogle, with the starting of Vanguard, and essentially, the launch of index funds. Now, this is where I depart with the rest of the historians and participants, because most people would look back and say that the index fund changed the world. That's not actually true. I think it's what the index fund enabled. And what the index fund enabled was being able to offer investment products at low cost and low fees. If you were to poll people: What is a market-cap-weighted index? I'm guessing if they were honest, most people would have a hard time describing it, because I've polled a lot of friends and even people that are in the industry. And a lot of people struggle.
They say, "It's the largest stocks in the U.S. stock market, the largest companies." And I say, "Yes, by what measure?" They say, "By size." And I say, "What does that mean?" They'll say, "By revenue or sales or earnings." I say "No, no, no. A market-cap-weighted index is simply the price of the stock times the shares outstanding." It is the ultimate momentum and trend index. Now, that is not a bad thing. Let's be very clear. Because it guarantees you own "the market." As a stock gets to be bigger and bigger--think about Apple, multi-trillion-dollar companies today--with market-cap-weighting, you own more and more of it. As the stock goes down--think Enron, or something-- you own less and less. Why does that work historically? Because you are guaranteed to own the winners. And it becomes a fantastic way to invest. But it is a very curious way to invest. If you were to talk to Warren Buffett or anyone else about buying housing or your local pizza parlor, no one would do it based on market-cap weighting. But here we are 50 years later.
The challenge of market-cap-weighting is it has no tether to fundamentals. It often overexposes you to bubbles. And as things get more and more expensive, you own more and more of them. And if you look back over the course of the last 100 years, our favorite metric is the 10-year price/earnings ratio adjusted for inflation--people call it the Shiller CAPE ratio. It doesn't matter, all the valuation metrics always say the same thing. You could use dividend yield, doesn't matter. But if you look back in history, stock markets, on average, trade around 17 on this CAPE ratio. In lower-inflation times it's allowed to be higher.
But there have been times in history when the U.S. market has been as low as 5; it's been as high as 44 in the '99 bubble. By the way, it's at 39 today, the second-highest it's ever been--we'll come back to that. So, the problem is, you own more as things go up. Japan, for example, in the 1980s was the biggest bubble we've ever seen. It hit a long-term P/E ratio of almost 100. The Japanese stock market then went nowhere for 30 years. And this wasn't some backwater economy; it was the largest stock market in the world at the time. So, if you are an indexer, globally you put most of your money in the most-expensive stock market of all time at the exact peak. It's the exact opposite way you should be investing. And now on the flip side, too, when things get super cheap, when no one wants them, when they are a P/E ratio 5, you invest the least.
Now this applies not just to global countries, but also to sectors and to industries. There have been lot of great studies by many different academics and practitioners--Research Affiliates is one of my favorites. They show the largest stock in a market-cap-weighted index goes on to underperform that index by about 3 percentage points per year for the next decade--not one or two years, for the next decade. This applies in every sector, it's even worse in some countries. So, the long-winded answer to your question: The first thing you can do is break that market-cap link; you can invest in any way other than market-cap-weighting. That will give you, hopefully--we prefer value, like you mentioned--a tilt toward things that are cheap and that should, we think, outperform market-cap-weighted indexes by 1 or 2 percentage points per year.
The problem right now in 2021, of the 45 countries around the world, the U.S. is one of the most expensive markets in the world. The U.S. is also the largest market cap just like Japan was in the '80s. The U.S. is up around 39. And the good news is most of the rest of the world is totally reasonable to downright cheap to screaming cheap. I'm happy to talk more about that. That was a long-winded answer to your question. But as you think about construction-- I'm going to tie a bow on this at the very end--going back to Bogle, Vanguard actually manages more active funds than they do passive. Now they have more assets in passive. But this term over 50 years has been totally corrupted. It used to mean one thing and one thing only: market-cap-weighted indexes. But now it means all sorts of things. And so, he himself said before he passed, he said the conflict of interest in the industry is not active versus passive. It's high cost versus low cost. So, you now have a world where you can have active funds that are super cheap, and passive funds that charge 1.5%. So, the whole point on this is focus on low costs. And also preferably use a little common sense and break the market-cap link.
Jeff Ptak: What do you make of the fact that with respect to fund flows, at least here in the U.S., we've actually seen investors net selling things like U.S. stock funds, despite the fact that multiples are higher and the litany of facts that you laid out. And, actually, they've been net buyers of international-stock funds, which is the opposite of what I think we've been accustomed to seeing. When you look at that data, how do you reconcile it with the rest of the picture that you're seeing and describing for us?
Faber: It's great. It means they've been listening to The Meb Faber Show and reading some of my books, I guess. But, seriously, if you look at the U.S., with a 39 P/E ratio, foreign developed markets are down around 22, emerging-markets are down around 15. And then the cheapest bucket, the detritus at the bottom of the ocean, is down around 12. And the challenge, and you guys know this more than anyone, is every investment has its day in the sun and day in the shade. The problem with most people is these regimes last a lot longer than they expect. So, we're not talking Robinhood time frames of minutes and hours and days and quarters or even years, but decades. If you look at the 2000s, the darlings of that decade were emerging markets, commodities, real estate, small-cap value. And then what has it been the last decade? It has been nothing but the U.S., baby--all U.S. stocks, market-cap-weighted--which has led us to write an article called "The Biggest Valuation Spread in 40 Years?"--U.S. versus the rest of the world.
And the difference is if you look over the last 40 years, people love to say, "No, no, Meb, you don't understand, you can't use CAPE ratio for all these reasons; you can't use valuation. The U.S. is special." And I say, "I agree, it is special." They say it deserves a premium. And I say, "What do you think that premium should be?" And they come up with the number and I say, "Over the last 40 years, the premium of U.S. stocks versus foreign stocks is zero." It's technically not zero, it's like 0.5 or something. On average, they've had a valuation of around 22, for the last 40 years. The difference was, again, 40 years ago, the U.S. was cheap, and the rest of the world was expensive, in particular, Japan. So, there's always crisis going on somewhere. And if you look at the P in the P/E ratio, that's what drives it. There's some country usually down 40%, 60%, 80%, 90%.
I was in Bogota about five years ago giving a speech and was very unpopular, because I told all the locals, "I love your food, I love this country, it's beautiful. But your stock market is super expensive." It was in the 30s at the time, it might have even been 40. And I said historically that's not been a warm, fuzzy place to be. And they've had a horrific return since. But everyone pulled me aside and said, "Meb, you don't understand," and listed all the reasons why the market would continue to go up. And so, having this valuation perspective, I love it. Nothing makes me happier than to hear people say they're allocating to foreign; my experience is most don't. So, the starting point is, if you look at just stocks, we would say roughly is half U.S. and half foreign, emerging markets down around probably 13%. The average person to allocate emerging markets is 3% out of the total. And getting away from what we call home-country bias makes a lot of sense.
Every country around the world allocates way more to their own country than they should. And it's particularly problematic in two scenarios, one where the country is tiny. So, if you're 3% of the world market cap, like Canada or something, and you're putting in 70% in Canadian stocks, for a Canadian that's like junior miners and cannabis, that's their barbell. It's a huge overweight, that's a huge active bet. Maybe it'll work out, but you go ask all these countries around the world over the last decade, and in likelihood, it won't. So we did a post on our blog called "The Case for Global Investing," and if you look back in history, you go back to 1900. The U.S. has stomped everything this decade; pat yourself on the back if you've been overweight the U.S., have a glass of champagne and toast your friends. But then that's actually pretty rare. It's happened, I believe in the '90s. And then before that, you got to go back to, I think the 1910 decade, where the U.S. outperformed the broad average.
So, people love to extrapolate the recent past. But historically speaking, the world is your oyster. Looking beyond your borders any given year, 75% of the best top-100 stocks' performance globally is outside the U.S. So, as a quant, we would say that you want a lot of breadth. You want more choices than less. And there are a lot of gems outside of our borders.