Investor’s Insight: Market Valuations And Stock Returns – Part 2 by Steven De Klerck
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Weigand and Irons (2007) focus exclusively on the US stock market. The question arises whether there is also a significant negative relationship between current valuations at country level and future stock returns. Otherwise said, do the cheapest valued countries have significantly higher future stock returns compared to the highest valued countries? Various studies (Asness et al., 1997; Montier, 2007; Asness et al., 2013; Ellahie et al., 2014) give a positive acknowledgement on this matter. These studies document a significant positive relationship between the earnings yield (the inverse of the price-to-earnings ratio) and/or the book-to-market ratio (the inverse of the price-to-book ratio) on the one hand and future stock returns on the other. Otherwise said: the cheaper, the higher the average future stock return. Once again, current valuations can be used as an important source of information about future stock returns at country level.
Ellahie et al. (2014) also show that companies in countries with the cheapest valuations experience a recent drop in profitability and they are characterized by greater uncertainty with regard to earnings growth, findings that fit in with the well-known results by Fama and French (1995) at individual stock/company level. Consequently, telling a positive marketing story to client investors in these circumstances is extremely difficult for asset managers. Right now (December 9, 2014), I’m for example considering countries such as Brazil or Russia. Given the significant corrections in both the stock market and the exchange rate over the past years, the comforting story of a few years ago has turned out to be of little substance.
The focus on valuation numbers, the absence of a nice marketing story and a fine accompanying track record for the past period, the need for diversification over various cheap countries (diversification implies that the chances for huge payoffs are virtually nil) and the possibility for further underperformance during the next months make clear why asset managers – following their client investors – often remain on the sidelines. Career risk takes its toll. The aforementioned studies however demonstrate that investors frequently are given the choice: a comforting story at the onset followed by disappointing long term returns or else a less encouraging story at the onset followed by attractive long term returns. In the human psyche, we often notice that (apparently) negative circumstances are mistakenly equated with a high investment risk whereas (apparently) positive circumstances are equated with a low investment risk.
In investment analyses, valuations are usually linked with various economic and/or business economic forecasts. As was the case at the end of Part 1, investors preferably ask themselves what is the objectively quantifiable added value that these forecasts offer. In absence of a clear answer on this matter, chances are high that as investors we have to do with fortune sellers.
Countries with high growth potential do not offer good equity investment opportunities unless valuations are low.