Trump Puts U.S. Valuation Premium at Risk

President Trump fancies himself a disruptor. But I doubt he had any inkling that he might disrupt one of the safest assumptions in investing: That the U.S. stock market should be priced like a developed market and not like an emerging one.

Let me explain. There’s a noticeable gap in how much investors are willing to pay for developed-market stocks compared with emerging-market ones over time.

For example, the price-to-earnings ratio of the MSCI EAFE Index — a collection of developed-market stocks that excludes the U.S. — has averaged 20.4 from September 1995 through January. By contrast, the P/E ratio for the MSCI Emerging Markets Index has averaged 15.1 over the same time. (That’s based on one-year trailing earnings, excluding negatives, for the longest period the numbers are available for both indexes.)

That price discrepancy  mirrors the historical P/E ratios of U.S. stocks. Until the end of World War II, many investors viewed the U.S. as an emerging market and priced its stocks accordingly. According to data compiled by Yale professor Robert Shiller, the one-year trailing P/E ratio for U.S. stocks averaged 13.8 from 1871 to 1945. Since then, the P/E ratio has averaged 17.6 — a premium befitting a developed market.

It may seem counterintuitive that investors are willing to pay a premium for developed-market stocks when growth rates — and by extension expected stock returns — are higher in emerging markets. In fact, that premium is more than a casual bias; it’s baked into the calculation of fair value P/E ratios.

Consider, for example, the build-up method of estimating fair value P/E ratios using inflation, real productivity growth and dividend yield. According to IMF estimates, inflation and real productivity in developed countries each tend to grow at roughly 2 percent a year on average over the long term. The current dividend yield for the MSCI World Index is 2.4 percent. The sum of the three variables is 6.4 percent, the inverse of which implies a fair value P/E ratio of 15.6 for developed-market stocks.

Compare that with emerging countries, where the growth of inflation is closer to 4 percent and real productivity growth approximates 3 percent a year on average. The dividend yield for the MSCI Emerging Markets Index is 2.4 percent. The sum of the three variables is 9.4 percent, which implies a fair value P/E ratio of 10.6 for emerging-market stocks.

As two thoughtful observers — Bloomberg’s Matt Levine and blogger Josh Brown — pointed out recently, the developed-market premium is simply about risk. Emerging countries tend to have less stable governments and institutions than developed ones. They also tend to be ruled less by law and more by arbitrary whims of individual government officials. That’s a precarious environment for business and investment.

Those risks aren’t just theoretical; they actually translate into more risk for investors. The MSCI World Index — a collection of developed-market stocks that includes the U.S. — has had a standard deviation of 13.7 percent in local currency from 1988 through January. The MSCI Emerging Markets Index, by contrast, has had a standard deviation of 21.8 percent — nearly double the volatility. (Standard deviation reflects the performance volatility of an investment; a lower standard deviation indicates a less bumpy ride.)

I’m not suggesting that the U.S. is comparable to an emerging country. But the new administration should be mindful that the developed-market premium is a privilege, not a right. It depends in large part on investors’ belief that a country has stable institutions and follows the rule of law. The early days of the Trump administration have some wondering whether that will continue to be the case in the U.S.

If the White House continues on its chaotic course, then the market may decide there’s more risk in the U.S. than previously assumed — whether or not Trump delivers on his promise of higher growth. Investors should then brace for another disruption: cheaper U.S. stock prices.

Soruce: Bloomberg Gadfly,