June 18, 2018
- New Publication: The Global Opportunities Investment Report 2018
High U.S. Stock Valuations Once Again
The market sell-off in early 2018 helped relieve some of the pressure from the highly-valued U.S. stock market, but after a few months of choppy recovery, we are right back up to high valuations.
Market Capitalization as a Percent of GDP:
Here’s a valuation check:
In 2014, the S&P price-to-book ratio was about 2.6. That’s the price of stocks divided by the shareholder equity (assets minus liabilities) of those stocks. This was a normal run-of-the-mill year, not a market bottom like when the price-to-book ratio was 1.8 in 2009.
Book value chart source: multpl.com
Right now in mid-2018, just 4 years later, the price-to-book value is 3.4. Hypothetically, if the price-to-book value of the market were to suddenly return to where it was in 2014, it would mean a 30% market sell-off.
Now, that would be exceedingly unlikely to happen without a big catalyst, like a recession. But it shows how seriously valuations can fluctuate within just a few years.
Corporate tax cuts and low interest rates partly rationalize high valuations. It makes sense for stocks to be rather fully-valued in times like these, when short-term corporate earnings are growing due to tax cuts, and bonds provide so very little returns.
But investors shouldn’t be shocked by 10% market corrections or more when things are fully-valued like this. And they shouldn’t be shocked if we have a year or two without positive returns, with choppy sideways market performance, as earnings catch up to stock prices and deflate valuations a bit as interest rates rise.
We might have a strong second half of 2018. It’s hard to say. But investors shouldn’t be surprised if we don’t. It’s important to do thought experiments with your portfolio regarding valuations once in a while. A 30% sell-off would seem crazy and frightening, but in reality it would just mean similar valuation levels to 2014. And the S&P 500 would still be higher than 2014 due to gradual EPS and book value growth over the four years since then.
I hold U.S. stocks, including index funds, but with the active portion of my portfolio I am focusing more on areas I think are cheap that have already had major corrections recently, like REITs and MLPs.
Whatever path you choose, just make sure you don’t consistently buy high and sell low, like most investors do:
Source: JP Morgan Guide to the Markets
Elections, Debt, and Tariffs, Oh My!
It’s certainly been an active few months for international markets.
-A strong U.S. dollar has resulted in most international holdings not doing so well for U.S. investors recently.
-After months of uncertainty resulting from indecisive elections (no clear majority party), Italy put in place a new coalition populist government.
-Spain’s prime minster was forced out amidst a major political corruption scandal.
-U.S. steel and aluminum tariffs took effect on Canada and Europe, and both regions vowed retaliatory tariffs.
-The U.S. recently announced 25% tariffs on $50 billion of Chinese imports. China vows to respond with equivalent-value tariffs on U.S. imports.
-President Trump and Chairman Kim Jong Un met in Singapore, signing vague-but-promising agreements.
-A week-long nationwide trucker strike over rising oil prices shut off highways across Brazil, hurting the economy.
This is why diversification is helpful. In 2017, international markets generally outperformed U.S. markets. In 2018, it has been a messier time for international markets. Holding a diversified portfolio that includes both helps smooth it out as the waves often offset each other.
It’s still worth paying attention to long-term risks, though.
Italy is a cheap market right now by most metrics (12.5 price-to-earnings, 1.3 price-to-book), but with 135% debt-to-GDP and lack of control over its own monetary policy, Italy seems to be a large sovereign credit risk for the European Union next time there is a recession affecting Europe.
Back when Greece’s economy fell apart, it was because debt went over 150% of GDP, government budget deficits were huge, and investors demanded higher interest rates. Italy is fine for now with budget deficits under 3% of GDP. But without something big changing its course, whenever Italy encounters the next recession with falling tax revenues, the deficit will widen, the debt will go upwards of 140% of GDP or more, and investors will likely demand higher interest rates. It doesn’t look fantastic over the long term.
On the other hand, South Korea’s market currently has a price-to-earnings ratio of about 10x, and a price-to-book ratio of about 1.15x, with moderate debt levels, gradual growth, and control over its own currency and monetary policy. Could a slightly less aggressive northern side of the peninsula help increase global investor sentiment towards South Korea’s market? I think this is a reasonable long-term buying opportunity overall.
The International Pyramid of Risk
Investors seek to get the best returns for the lowest amount of risk, and allocating a portion of your portfolio towards international markets can be a way to achieve that goal.
International investing is often associated with higher risk, and this has elements of both truth and falsehood.
On one hand, geographical diversification can reduce overall portfolio risk. By not putting all your eggs in the basket of your home country and home currency, you can spread your risk and rewards out among multiple regions of the world.
On the other hand, investing internationally often means investing in unfamiliar markets with currency risk. You don’t know the companies as well, and even if your assessment of a company or market is correct, unfavorable changes in exchange rates could gut your investment returns.
But this swings both ways: investing internationally can give you exposure to strengthening currencies for outsized returns, and can allow you to invest in undervalued markets even when your home market may be overvalued. Different countries are often at different stages of the business cycle.
Sometimes your home nation’s stock market becomes overvalued. When this happens, decades of data tells us that mean reversion occurs- your home market underperforms relative to international stocks for a number of years as valuations rationalize.
Here’s a chart of historical annualized stock performance for Europe, the Pacific region, and the United States, from various decades:
Source: Ben Carlson, CFA
Sometimes one region vastly outperforms another and becomes overvalued, and then lags other regions for a while.
As Ben Carlson calculated, if you were to invest in all three regions equally and re-balance once per year, your total return would be 10.6% per year, slightly higher than any of the three individually. And you’d have fewer no-growth decades.
That’s an example of how having international exposure in general can reduce your total portfolio risk, even if any individual international investment may be rather volatile.
Adding emerging markets and specific country exposure can allow investors to further take advantage of these fluctuations, to let you ride the waves to better returns.
Here’s a description of the four layers of risk involved as you go from local investing to international investing and onto emerging market investing:
Layer 1: Company Fundamentals
The first layer of risk is how well a company or economy performs fundamentally. This applies whether you’re investing in a specific company, or investing in a whole country or region’s economy with an ETF.
Fundamental performance refers to things like earnings growth rates, changes in debt levels, and that sort of thing. The first step to picking good investments is being correct about the forward underlying performance of the thing you’re investing in.
Layer 2: Market Valuations
The second layer of risk is that even if an investment’s fundamentals go the way you expect, reductions in the market valuation of that entity may move against you.
For example, suppose you invest in a company that makes $5 in earnings per share annually, and the share price is $100. The stock therefore has a price-to-earnings ratio of 20x. Let’s say you expect it to grow earnings by 8% per year for the next decade, so you make an investment.
If you are correct, then after ten years of 8% annualized earnings growth, the company’s earnings per share will be $10.79 per year. If the stock still has a 20x price-to-earnings ratio, the share price should be $215.80, implying that you earned 8% annualized returns on your stock investment.
However, if for some reason the market is only paying a 15x price-to-earnings ratio for the stock ten years from now, then the stock price would be only $161.85. Your annualized rate of return on the stock would therefore only be about 5% per year, despite the fact that earnings indeed compounded by 8%.
In this case, you were correct about the company’s forward performance, but nonetheless didn’t get the returns you wanted because the market applies different valuations to stocks over time depending on all sorts of rational and fickle reasons.
Therefore, enterprising investors must buy the right stock or ETF at the right price in order to have solid returns.
Layer 3: Exchange Rates
When you invest internationally, in addition to fundamental risk and market valuation risk, you also have exposure to the pros and cons of varying currency exchange rates.
Suppose, for example, that you invest in a Japanese company, and its fundamental performance goes exactly how you expect, and its price-to-earnings ratio increases because you bought at a great price. Let’s say earnings grew by 8% per year and its price-to-earnings ratio increased from 15x to 20x. This should be an awesome investment.
However, if the Japanese yen weakens considerably compared to your home currency, let’s say the US dollar, your investment might lose value to you in dollars anyway, even if the investment worked out well in terms of yen. And as a US investor in this case, it’s dollars that you care about and pay your expenses with.
In 2011, you could trade one dollar for 76 yen. That was the exchange rate. In 2015, this figure changed to one dollar for 124 yen. That’s a 63% de-valuation of the yen to the dollar in four years. It’s no wonder that American stocks massively outperformed Japanese stocks from 2011-2015 for American investors.
This works the other way as well. If you were a Japanese investor in 2011, and bought American stocks, you did very well for yourself over the next several years. The fundamentals of your investment were good, the valuation increased, and the foreign currency strengthened which accelerated your yen-denominated returns in a major way.
American holders of foreign stocks did very well in 2017, as another example, because the US dollar weakened compared to many foreign currencies.
Over the long term, stable currencies tend to revert to the mean. Exchange rates over 10-year periods between major currencies look like waves, rising and falling. But if you want to make good returns in a specific time period, it’s useful to pay attention to markets that have currencies that are strengthening compared to your home currency.
Lastly, some emerging market countries, both sovereign entities and corporations therein, hold debt in foreign currencies like US dollars, and their currencies tend to be less stable than currencies from highly developed nations. If their home currency that most of their revenue comes from weakens, but the foreign currency of their debt does not, it can dramatically increase their real debt burden and raise their risk of default.
Layer 4: Capital Flow
The final layer of risk applies mostly to emerging markets.
For many smaller countries in the middle stages of development, a large portion of the market capitalization of their stocks is held by foreign investors from advanced, wealthy nations, rather than by locals.
When institutions and investors from wealthy nations re-arrange their portfolios, it could result in significant capital inflows or outflows to certain countries.
For example, Thai citizens and institutions have very little impact on the U.S. stock market. But U.S. citizens and institutions hold a considerable share of Thailand equities (even as a small part of their overall portfolios), and if American investors decide to allocate less money to Thailand stocks, or less money to emerging market stocks in general, the valuations on Thailand stocks could fall rapidly.
To quantify that, total US household net worth is about $100 trillion. The market capitalization of all companies in Thailand is about $550 billion. Thailand represents about 4% of the FTSE emerging market index. If American portfolios decrease their average emerging market allocation from 8% of net worth to 5% of net worth, that’s a $3 trillion outflow of capital from emerging markets, of which $120 billion would be withdrawn from Thailand. That’s more than a 20% decrease in valuations for Thai stocks.
European investors, Japanese investors, and other wealthy nation investors add to that. If worldwide portfolios trim or add positions in emerging markets, even as a small portion of their portfolios, it makes a big difference for the valuations in the stock markets of emerging economies because of the sheer amount of capital that is moving around relative to the size of the markets.
In addition to major currency swings, capital inflow and outflow plays a part in why emerging markets can be so volatile. But this also gives enterprising investors attractive entry points when valuations are low.
U.S. and Canadian Midstream Opportunities
In the previous newsletter, I mentioned that I was potentially going to buy units of Spectra Energy Partners LP (SEP), which at $31.67 was trading at a significant discount to fair value.
In addition to Enterprise Products Partners (EPD) and Magellan Midstream Partners (MMP), SEP has been one of the most well-run and conservative MLPs, with low debt levels, top credit ratings among MLPs, and a long stretch of consecutive quarterly distribution increases.
Shortly after that, the partnership announced a strong first quarter, and the units rose to $33.49. However, its new parent company Enbridge then announced plans to purchase and consolidate all of its partnerships, including SEP. Their other partnerships were having liquidity problems, but SEP itself was still strong.
Under the proposed consolidation plan, SEP investors will receive 1.0123 shares of Enbridge stock for each unit of SEP they have.
This news was only moderately surprising since I knew it was a possibility that Enbridge would entirely buy SEP eventually, but what was truly striking was that the buyout gave SEP investors no premium for their shares. Usually a buyout like this would involve a 5-10% premium, especially considering that SEP had been trading as high as $46/unit in the past 52 weeks.
Its a smart move on Enbridge’s part to try to buy undervalued assets. It will improve their overall capital structure in a major way. But the way they went about this angered a lot of unitholders.
Over the long-run, since Enbridge stock is also attractively valued (and now they are planning to buy all these undervalued assets), the Enbridge shares that SEP unitholders will receive should do quite well over time.
However, it’s a stealth distribution cut for SEP unitholders. At the time of the buyout announcement, SEP had a distribution yield of over 9%. Enbridge’s was only over 6%. When investors have their SEP units replaced by ENB shares, it will mean a lower dividend/distribution yield, but much faster expected dividend growth. It’s not a bad tradeoff, but not necessarily what SEP unitholders signed up for when they bought their high-yielding SEP units.
Investors that currently hold SEP should probably continue to hold their units. The buyout is not final yet; it is subject to review by the SEP board including an independent conflicts committee. There is the potential for lawsuits from unitholders if the board accepts such a low-ball offer. It’s possible that Enbridge will be forced to sweeten the deal with a 5-10% premium.
In the meantime, the price of SEP shares is innately tied to the fluctuating price of Enbridge shares, since the buyout is priced in terms of Enbridge stock.
In the otherwise highly-valued U.S. market, I think certain midstream companies still offer considerable value.
Enterprise Products Partners (EPD) and Magellan Midstream Partners (MMP) are some of the most conservative choices. They have lower distribution yields (5-6%) than many other MLPs (which are often 8%+ these days), but in exchange they have fortress balance sheets and are self-funding, meaning they are no longer reliant on issuing new units to fund growth. Magellan has been self-funding for years now, while Enterprise is just hitting that goal this year. Both partnerships have top-notch management.
Enbridge (ENB) offers a potentially higher forward rate of return than those two, but with a bit more drama. Enbridge took on a lot of debt when it bought Spectra Energy’s general partner a few years ago, and is paying that debt down. In addition, it has political uncertainty regarding approval for its Line 3 project between Canada and the United States. A decision for this will be reached in July, and that could result in a significant stock price swing up or down depending on the outcome. And of course, the recent news of Enbridge consolidating its partnerships provides a degree of uncertainty and messiness until it is finalized. However, Enbridge has a great credit rating, low payout ratio relative to cash flow, and is likely to have high dividend growth over the next several years. The company has 23 consecutive years of annual dividend growth.
In my opinion, Enterprise Products Partners is a great choice for conservative income-focused investors, while Enbridge is potentially the better total-return investment at current prices for investors willing to take on some drama and uncertainty in exchange for access to their undervalued wide-moat infrastructure.
As such, my most recent investment was Enbridge at around $31/share USD.
My Personal Portfolio Updates
My primary retirement account is purely indexed, and currently consists of about 40% U.S. stocks, 20% international stocks, and 40% short-term bonds and cash.
From 2009 through 2016 it was more aggressively positioned in equities that enjoyed a long bull market, but in 2017 I began dialing back my equity exposure a bit due to high valuations. I’ll significantly increase my equity exposure if/when valuations decrease substantially.
In addition, I have two other accounts that I make more active investments in, including individual stocks, ETFs, and options. Here is their combined summary:
I manage all of my accounts and monitor my net worth by using the free tool from Personal Capital, which makes everything easy.
Changes since the previous issue:
-I was looking into investing in Spectra Energy Partners (SEP), but after the Enbridge announcement about their plan to consolidate its partnerships, I went ahead and invested in Enbridge (ENB) instead.
-My cash-secured puts on Synchrony Financial expired profitably. I might use this freed-up capital to buy more units of Brookfield Infrastructure Partners (BIP) in the current price slump under $40/unit.
-I profitably bought-back my June $7 puts on SunPower Corp and sold more aggressive $8 September puts. This remains my smallest holding.
Virtual ETF Portfolio Updates
Each newsletter for fun, I update a virtual ETF portfolio.
It takes a few minutes per newsletter to manage, and helps show where I think value is in the market without focusing on individual securities.
You can see the previous version from the May issue here.
Currently the S&P 500 is at 2779.66 and the S&P 500 TR is at 5469.37.
Changes since the previous issue:
-I profitably bought back the covered call options on EWZ. Selling those calls in the first place helped offset some of the decline in Brazil’s equity prices over the last few months. Brazil is likely going to be a wild ride at least until the election later this year.
-For portfolio simplification for developed international exposure, I sold the remaining 200 shares of IDV and invested part of that into 100 more shares of VEA.
-I sold two puts on the VanEck Vectors Gold Miners ETF. This position will generate income and provide further diversification into metals.
-The portfolio collected $0.7318/share in distributions from VNQ.
Final Thoughts & International Report
I haven’t written any articles on this site for a few weeks because I’ve been finishing the newly-published Global Opportunities Investment Report.
This report standardizes data for the debt, growth, valuation, political stability, and currency strength of most of the world’s invest-able countries, so that enterprising investors can see where undervalued opportunities may be found with single-country ETFs.
Rather than just focusing on which markets are cheapest, this report focuses on where the best overall values seem to be, involving several metrics.
In two days I will release the report on the main site for $19.95. Newsletter subscribers can access it here for the next two days for $14.95 (25% off).
It’s a great way for frequent readers to support the site and free newsletter, and learn about all the major international markets. There are some interesting undervalued opportunities out there; some international markets offer great return potential while U.S. stocks are rather highly-valued overall.
Over the next month, I’ll be back to writing articles, and plan to publish the next newsletter issue in early August, where I will do another update on current recession indicators.