Vive La Difference

Mike Zaccardi

THERE’S A LOT of handwringing right now about U.S. stock market valuations. Prof. Robert Shiller’s cyclically adjusted price-earnings ratio, or CAPE, has rarely been more famous—or perhaps infamous. It’s currently perched near 39, meaning buyers of the S&P 500 are paying almost 39 times average inflation-adjusted corporate earnings for the past 10 years. That number might mean little to many without proper context. It was around five at the worst of the Great Depression, and under 10 in the late 1970s and early 1980s.

Jump ahead to the dot-com bubble and you’ll see that it peaked at 44 in December 1999. After that came an historic drop in share prices. With the current record-low interest rates and huge fiscal spending, we’re nearing those lofty late 1990s highs once again.

It’s likely some investors have thought about moving some money from U.S. stocks to foreign markets. After all, CAPE ratios are far lower in many other developed markets. There’s a twist, though: The U.S. market’s composition looks nothing like some of those foreign markets.

For example, the technology sector is 24% of the S&P 500 using Vanguard S&P 500 ETF (symbol: VOO) as a proxy. Leap across the pond to Europe, and you’ll discover that just 8% of Vanguard FTSE Europe ETF (VGK) is in the tech sector. Fast-growing tech stocks command higher valuation multiples than cyclical and defensive sectors such as materials, financials, staples, energy and industrials. All of these sectors feature more prominently in Europe’s market makeup.

The quants out there can perform a sector-neutral valuation analysis to get a truer sense of each country’s stock market valuation. Indeed, looking beyond a standard valuation metric such as the CAPE ratio would be wise, especially if you’re considering making major changes to your stock portfolio’s geographical allocation.

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1 year ago

Great post!

I was in the tech industry during the dot com boom. I realized how frothy it was when two guys at a conference were talking about a hot stock. I mentioned a crucial flaw in the company’s business model. One of these guys said, “What do I care about that? I am selling this stock tomorrow.”

We are currently experiencing, in my observation, the fastest tech shift of the past twenty years, under duress because of the pandemic. Ideas that had been floating around as concept projects have now been applied nationwide where long standing policies and procedures were thrown in the dumpster under the circumstances. Though many find ample flaws in remote learning and remote work, the scale at which they’ve been implemented is unprecedented and return to pre-pandemic work life seems a very slow process (even though San Francisco has some of the lowest Covid numbers, for instance, BART ridership is now only 22% of its 2019 pre-pandemic numbers). Contactless transactions are expected. My college student will use her cell phone for keyless entry into all buildings, and no more
card swipes, taps only at the cafeteria and library.

Such a massive shift has corollary impacts. Just on the tech side, hardware and software need bug fixes, updates, and ultimately will degrade. Managing networks, security, privacy, data compression, contracts with communication technology partners. Lots of work and new ideas in all that. The geography of these technologies — which can be destabilized as we’ve seen during the pandemic — may suggest to some where their investing dollars will provide preferred returns (That prognostication not my area of specialization, so broad market indexes remain my choice.)

1 year ago

The US S&P 500 is cap-weighted, so a mere 6 stocks, all techs, constitute 30% of the index. These six stocks have led the S&P up to record levels, but the real question is whether they will continue to have the growth that their prices imply. It is not often that companies that are already large can continue to grow at the rate of 10-15% every year, for ever and ever. Since the overall growth of the US economy is only 2-3% a year, many analysts would say this is unlikely.

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