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Eric Fry, trusting that opposites attract, reports...
A few months back, we proposed a somewhat novel idea: Sell U.S. stocks and buy European stocks... as a "pair trade." We wrote:
Sell short the SPDR S&P 500 ETF Trust (NYSE: SPY) and then buy an equivalent dollar amount of the SPDR Euro Stoxx 50 ETF (NYSE: FEZ)...
For several years running, the U.S. stock market has been a one-directional market: Up. But maybe it is capable of moving in a different direction, like sideways... or even down. Who knows?
What we do know is that U.S. stocks have been big winners, relative to European stocks, during the last five years. The S&P 500 ETF has doubled, while the Euro Stoxx has gained a miserable 6%, total - that's barely 1% per year.
As a result of this impressive, five-year divergence, U.S. stocks have become very richly priced, not just relative to European stocks, but also relative to most foreign stocks around the globe.
It is possible, of course, that U.S. stocks will continue their world-beating performance and will continue to diverge from European stocks. But valuation convergence seems like the path of least resistance from here. U.S. stocks may not suffer any major reversals, but one way or another, they will likely lose some of their premium pricing relative to European stocks.
Since proposing this pair trade on March 17 - and despite yesterday's Grexit-inspired shellacking in Europe - it has produced a modestly positive result, which is better than the negative result the S&P 500 has delivered over the same time frame.
Therefore, inspired by the (very) modest early success of our "Sell U.S., Buy Europe" pair trade, we return today to propose a slightly larger version of the same idea: Sell the U.S... Buy the World!
Sell the U.S... Buy the World
If you needed a reason to lighten up on U.S. stocks, the chart below should do the trick. Take a good, long look at it... We'll wait.
The chart shows the total market value (i.e., "market cap") of all U.S. stocks, expressed as a percentage of U.S. gross domestic product (GDP). This calculation is called the "Buffett Indicator" and it is telling us that U.S. stocks are expensive... very, very expensive.
Mr. Buffett did not invent this valuation gauge, he merely praised it publicly. Back in a 2001 interview in Fortune, Buffett lauded this indicator as "the best single measure of where valuations stand at any given moment."
It has been called the "Buffett Indicator" ever since.
According to this "Big Picture" valuation gauge, a stock market is relatively cheap whenever its market cap drops well below 100% of GDP. Conversely, a stock market is relatively expensive whenever its market cap climbs well above 100% of GDP.
At the stock market lows of 2009, for example, the market cap of all U.S. stocks plummeted to less than 60% of U.S. GDP. But today, the U.S. market cap totals a whopping 141% of U.S. GDP, which is more than double the average readings of the last 65 years. Today's 141% reading is also the second-highest level this metric has ever reached during the last 65 years.
If you need a second reason to lighten up on U.S. stocks, take a look at the next chart. It shows that the price-to-cash-flow ratio of the S&P 500 Index has soared to within a whisker of the extreme reading this indicator hit in 1999, just before stocks swooned into the deep bear market of 2000-2003. ("Cash flow," in this case, means EBITDA, or earnings before deducting interest, taxes, depreciation and amortization. This profitability metric is very handy because it eliminates the impact of accounting decisions and protocols that differ from company to company and country to country.)
Taken together, the Buffett Indicator and the S&P 500's lofty price-to-cash-flow ratio both suggest that the U.S. stock market has "decoupled" from underlying economic trends.
In the parlance of the investing industry, this sort of decoupling is called "multiple expansion" - a delightful process that enables share prices to soar, even when the underlying economy isn't doing much of anything. Stock prices rise because investors become willing to pay ever higher prices for each dollar of earnings or cash flow. So, for example, instead of paying $7 for every dollar of a particular stock's annual cash flow, investors decide to pay $8 per dollar of cash flow, then $9, then $10, etc.
Multiple expansion is fun. It makes stocks go up. But there is a dark side to extreme multiple expansion: It often precedes its evil twin, multiple contraction.
After all, investors can decide to pay lower multiples just as easily as they can decide to pay higher multiples... especially if a selling panic takes hold. That's why multiple expansion is one of the flimsiest of all stock market foundations... and why it's usually a good idea to tiptoe away from pricey markets.
Imagine, for example, that the spectacular U.S. stock market reverted to merely average.
If the S&P 500 index fell to its average price-to-EBITDA ratio of the last 35 years, it would drop more than 30%. The Buffett Indicator presents an even scarier prospect. If the U.S. stocks were to return to their average Buffett Indicator readings of the last 65 years, they would plummet more than 50%!
Bottom line: U.S. stock market valuations are extremely rich... especially when one considers that stock market valuations outside the U.S. are much, much lower than they are here at home.
Foreign stocks have not participated in the same sort of multiple expansion process that has powered U.S. stocks to such lofty levels.
Based on the Buffett Indicator, for example, the non-U.S. portion of world stock market capitalization totals only 80% of non-U.S. world GDP. This reading is well below the Buffett Indicator reading for U.S. stocks.
Similarly, the current price-to-EBITDA ratio of the MSCI EAFE Index of international stocks is nowhere close to the S&P 500's price-to-EBITDA ratio.
Given the gaping valuation disparity between U.S. stocks and their foreign counterparts, we say, "Sell the U.S.; Buy the world!"
Specifically, we suggest selling short the SPDR S&P 500 ETF Trust (NYSE: SPY; Price: $205.42) and then buying an equivalent dollar amount of the iShares MSCI EAFE ETF (NYSE: EFA; Price: $63.72). This sort of pair trade is a classic "convergence trade," which succeeds if the prices of the SPDR ETF and the MSCI EAFE ETF converge toward one another. (On the other hand, the trade would produce losses if the prices of the SPDR ETF and the MSCI EAFE ETF diverged from one another.)
Importantly, this sort of pair trade does not subject investors to "directional volatility." In other words, it could succeed, even if global markets are falling, provided that the SPDR ETF falls more than the MSCI EAFE ETF.
That's the sort of hedged position that could come in very handy during the weeks and months ahead, especially if yesterday's rocky trading session was a taste of things to come.
Cheers,
Eric Fry
For The Non-Dollar Report
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