Bernstein: European Stocks Look Cheap

Christine Benz: Hi, I'm Christine Benz for Morningstar.

I recently attended the annual Bogleheads Conference, and I had the opportunity to sit down with Dr. Bill Bernstein. Bill is the author of several books on investing and asset allocation, and he shared some of his views on key asset classes in our interview.

Bill, thank you so much for being here.

Dr. Bill Bernstein: My pleasure.

Benz: So, Bill, equities have been pretty beaten up over the past summer. They've come back a little bit, but you recently sent a note to me, I was asking you if there were any big themes that jumped out at you in advance of the conference, and one thing that you said was that, equities looked pretty reasonable now, after looking somewhat overvalued in the recent past. Let's talk about what you're seeing and how you're arriving at that conclusion.

Bernstein: Well, simply by the basis of valuation metrics. The earnings of the S&P 500 now are somewhere in the mid-80s. So even at an S&P of 1,200, you're looking at a P/E of around 14, which is about the historical average, and when the PE is in the 14 range and you look forward to what happens, you generally get a fairly salutary return. That doesn't mean they can't get cheaper, but if you start purchasing equities now, in the long run, you should do reasonably well.

You can always say, well equities can get cheaper, no matter how cheap they get, and that's true, but the problem is if you keep your powder dry, and you're wrong, you may wind up watching the market climb away from you, and never earn those equity returns. So, certainly the person who is putting money away into a 401(k) plan, I think, in good conscience can be buying stock funds.

Benz: So, on a measure like Shiller P/E, though, the stocks don't look quite as inexpensive as a 14.

Bernstein: I'm a big fan of the Shiller P/E. The problem with it is that the average value of that is said to be 16, but that's only if you go back to 1871, when industrial stocks sold for five and six and seven times earnings. If you look at the Shiller P/E after 1951, then the average is about 19, that's the first point.

The second point is that the 10-year rolling real earnings right now for the first time in a long time includes two major recessions, two major earning depressions, and so, you know, in another two years, the first recession, the '00 to '02 recession is going to go out of those numbers. So, if things don't change, if the price of the S&P simply just doesn't change from here, then you'll be looking at a Shiller P/E that's close to the 15 or 16.

Benz: Okay. So, U.S. markets somewhat fairly valued--maybe a decent opportunity to be dollar-cost averaging in at least. European stocks, though, you think are genuinely distressed, genuinely cheap. Let's talk about how you're arriving at that.

Bernstein: Well, again, I'm just looking at the P/E values of the indexes, and the P/E of the EAFE Index, the P/E 10 of the EAFE Index if you want to take that, using the Shiller measure, is somewhere around 11 or 12 right now, which is certainly inexpensive. It's not hard to find individual European stocks that are selling at single-digit P/Es, and the dividend yield of European stocks right now is fairly close, I think, to 4%. So, the European stocks are pricing into them a real Armageddon, and if that Armageddon doesn't occur, then you'll have fairly decent returns. Even if it does return, I think that's already been priced into the market.

Benz: So, how would you play something like that if you see a pocket of what appears to be pretty compelling opportunity. Would you buy a total Europe index or just obtain that Europe exposure via a total international stock index.

Bernstein: I think that depends on the personality of the investor. There are some people who just don't want to think about investing--investing is root canal for them--and they want to keep things as simple as possible. So, a good total international stock fund should be their exposure to equities, perhaps 25%, 30%, 35%, maybe even 40% of the equity portion of the portfolio--not of the whole portfolio, of course. If they're 60/40, they should be at least 15% or 20% of the whole portfolio.

And if they are the kind of person who enjoys investing and likes to think about sub-asset classes, then you can start putting money into a European stock fund like the Vanguard index stock fund or the appropriate ETF to that.