Rob Arnott: U.S. Most Expensive Stock Market in the World

Wed, May 22, 2019 - 3:04pm

Despite the simmering threat of trade wars and rumors of real wars brewing, U.S. stock market valuations remain high. Financial Sense Insider spoke with Rob Arnott, founder and chairman of Research Affiliates, about his take on sky-high valuations and what he sees ahead for the markets.

Market Valuations

U.S. markets are especially expensive by historical standards. Arnott said, “The U.S. is home to some of the most expensive stocks in the world and to the most expensive stock market in the world. It's priced for perfection. It's priced as if nothing could go wrong.”

The FANG stocks in particular are a big part of the U.S. stock market’s current high price and are reminiscent of the tech bubble in 1999 to 2000. Today companies are priced as if nothing could go wrong, Arnott said. The problem with this, he said, is that normal valuation levels can change. The merits for such lofty levels could easily be lost in 10 years and the valuations gone.

Of the 10 largest market capitalization technology companies at the time of the Tech Bubble, Arnott pointed out that three disappeared entirely, five produced negative real turns and nine of the 10 underperformed the stock market.

fang valuations
Source: Research Affiliates, "Are Valuations Irrelevant?"

There are better opportunities in other stocks and markets around the world priced at levels that don't reflect lofty expectations, Arnott said. These may have plenty of room for upside surprise on unexpected news.

In China, for example, Alibaba and Tencent would have made it into the top eight market cap companies in the world just a few months ago, Arnott said, but have since faltered. In contrast, the FANG stocks plus two additional stocks have an aggregate market cap that's larger than China, inclusive of both Tencent and Alibaba.

“The simple fact is that not all of them will succeed,” Arnott said. “You can play the guessing game and try to figure out which ones are going to be winners in the years ahead… You need to ask the question, which of these companies is going to exceed those lofty expectations enough to wind up beating the stock market? My guess is very few of them will.”

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Pricing the Current U.S. Market

The Shiller Price-to-Earnings Ratio is commonly used to help evaluate stocks. This metric produces a reliable measure of valuation, Arnott explained, by taking price relative to historical 10-year smoothed earnings to remove the effects of the economic cycle in valuing stocks.

The U.S. stock market’s historical Shiller PE ratio — its price relative to its 10-year average earnings — is about 17 times earnings. Today's valuation is twice that at 34 times earnings, Arnott noted. Over the last quarter century, the average is 23 times earnings, which we can take as the norm for this period.

arnott valuations
Source: Research Affiliates, "Are Valuations Irrelevant?"

This figure has been higher only once in history, during the peak of the tech bubble in 2000. “From today's valuation levels, I can say with considerable confidence that your 10-year return on U.S. stocks will be shockingly low. It might not even be positive,” Arnott said.

If a stocks’ price-to-earnings ratio is at 34 times earnings, for every $100 you invest, companies only make $3. Outside the U.S. in emerging markets, the PE ratio is around 14 to 16 times earnings. In Europe, it sits at about 16 to 18 times earnings.

Weighting Valuations

Arnott’s company, Research Affiliates, created the Fundamental Index, which differs from most index funds in its weighting strategy. Most funds weight the portfolio proportional to the value of each stock’s market capitalization, which is known as cap weighting.

The Fundamental Index weighs each company in proportion to the size of its business, Arnott noted. A large company has a proportionally high weighting, and a small company has a low weighting.

This method has an enormous advantage, Arnott stated, in that if a company is trading cheaply, an indexing using the fundamental approach is going to have more invested in it than a cap-weighted index.

For example, the Shiller PE Ratio on the Fundamental Index for emerging markets is nine times earnings. The index is buying half the world's GDP, Arnott noted, and paying nine times earnings for the average company weighted in proportion to the size of the business.

This produces a portfolio that mirrors the look and composition of emerging market's economies instead of matching the emerging market’s stock market. “If you're boosting your exposure to value stocks and lowering your exposure to growth stocks, you have a strategy with a strong value tilt, but it doesn't throw out the growth stocks,” Arnott said.

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