Wells Capital Management Economic and Market Perspective November 13, 2015 Bringing you national and global economic trends for more than 30 years The U.S. Stock Market Resides at a Unique Global Zip Code James W. Paulsen, Ph.D Chief Investment Strategist, Wells Capital Management, Inc. After following a similar path for much of the last 20 years, the U.S. stock market has recently dominated global stock markets moving to a unique zip code among world markets. Moreover, while both sales and earnings per share among U.S. stocks have mostly continued to rise, share earnings and sales have generally been in a declining trend in both foreign developed and emerging economies since 2011. Finally, because U.S. stock performance has led global returns in the last four years, the U.S. stock market has become increasingly expensive relative to foreign alternatives both on a price to earnings and on a price to sales basis. The uncommonly wide divergence today between the domestic and foreign stock markets primarily reflects a significant difference in economic performances. For example, while most global economies continue to struggle with very sluggish or slowing growth and high unemployment, the U.S. economy is one of the few in the world nearing or already at full employment. We believe this rather odd and wide divergence in the performance and character of the U.S. and foreign stock markets suggest investors should be boosting equity exposures abroad. Relative to the U.S., foreign stock markets are underowned, offer a better valuation, are surrounded by hospitable rather than hostile economic policy officials, and are comprised by companies whose earnings recovery is still in a much younger stage compared to the aging earnings cycle facing U.S. companies. Moreover, we suspect a forthcoming bounce in global economic growth will soon shift interest toward foreign stocks initiating a period of outperformance by international stocks. Consequently, investors who have been solidly rewarded in recent years from overweighting U.S. stocks, may want to consider a new zip code for some of their assets during the balance of this recovery. U.S. stock market diverges Exhibit 1 compares the U.S. stock market to foreign stock markets since 1995. Chart 1 compares the U.S. market to the global stock market excluding U.S. stocks and Charts 2 and 3 overlay the U.S. stock market with the global developed world and with the emerging world stock markets. Until 2013, as shown in Chart 1, although the magnitude of their respective movements differed, the U.S. and foreign stock markets moved very closely directionally. For example, both rose between 1995 until 2000, both then declined until 2003, both rose again until 2007, both then collapsed in 2008 and both rose again in tandem between 2009 until 2012. However, since 2013, the U.S. stock market has diverged directionally with foreign markets by the largest amount and for the longest time since at least 1995. Since 2012, the U.S. stock market is up by about 50% while the ex USA stock market has been essentially flat. Chart 2 shows a similar divergence between the U.S. stock market and the foreign developed world stock market. In this case, the directional relationship remained quite close until 2014 when U.S. stocks continued to rise and foreign developed markets declined. Indeed, since the end of 2013, foreign developed stocks have declined by about 11% while U.S. stocks have climbed an additional 12%.
Exhibit 1: Stock markets Chart 1 U.S. vs. rest of the world Solid (left scale) -- MSCI U.S.A. Stock Price Index, natural log scale. Dotted (right scale) -- MSCI World Free ex U.S. Stock Price Index, natural log scale. Chart 2 U.S. vs. rest of the developed world Solid (left scale) -- MSCI U.S. Stock Price Index, natural log scale. Dotted (right scale) -- MSCI Developed Country World ex U.S. Stock Price Index, natural log scale. Chart 3 U.S. vs. emerging economic world Solid (left scale) -- MSCI U.S. Stock Price Index, natural log scale. Dotted (right scale) -- MSCI Emerging Country Stock Price Index, natural log scale. 2
Chart 3 shows that the directional relationship between the U.S. stock market and the emerging stock market has not been as close. However, outside of their significant divergence during the late 1990s Asian crisis, the rest of the time between 1995 and 2012, emerging market and U.S. stocks moved directionally quite closely. Since the end of 2011, however, emerging market stocks have declined by about 10% while U.S. stocks have risen by almost 66%! As shown by all three charts, while the U.S. stock market eclipsed its previous all-time record highs several years ago, neither developed nor emerging stock markets have been able to reach previous record highs in this recovery. What stands out is not that the U.S. stock market has outperformed foreign stock markets. This has happened several times in the past. Rather, it is the magnitude and persistence of directional divergence between the U.S. stock market and foreign markets which is exclusive. The fact that the U.S. stock market has moved to a different zip code in recent years relative to global markets is historically unique. Most importantly, what does this unique divergence currently imply about the future risk-reward profile of the U.S. stock market relative to foreign alternatives? Since 2011, in both developed and emerging economies, earnings performance has diverged from the U.S. experience. As shown in Exhibit 2, the degree and duration of this earnings divergence is unprecedented. Interestingly, as shown in Exhibit 3, foreign sales results have only diverged significantly from those in the U.S. since mid-2014, although the divergence has been one of the largest outside of a recession since at least 1995 (see Chart 7). The fact that U.S. earnings performance has diverged more than sales performance reflects how much better U.S. companies have been at maintaining and expanding profit margins compared to most foreign companies. Fundamentals have clearly diverged in this recovery in favor of U.S. companies. The question is whether this rare fundamental divergence is ultimately resolved by foreign companies (and thus foreign stocks) experiencing far greater fundamental improvements compared to U.S. companies during the balance of this global recovery? U.S. company fundamentals diverge The U.S. stock market has directionally diverged from global markets primarily because U.S. company fundamentals (earnings and sales trends) have directionally diverged from most foreign companies. 3
Exhibit 2: Earnings Chart 4 Trailing 12-month earnings per share* U.S.A. vs. rest of the world Solid (left scale) -- EPS on MSCI U.S. Stock Price Index, natural log scale. Dotted (right scale) -- EPS on MSCI World Free ex U.S. Stock Price Index, natural log scale. Chart 5 Chart 6 Trailing 12-month earnings per share* Solid (left scale) -- EPS on MSCI U.S. Stock Price Index, natural log scale. Dotted (right scale) -- EPS on MSCI Developed Country World Free ex U.S. Stock Price Index, natural log scale. Trailing 12-month earnings per share* Solid (left scale) -- EPS on MSCI U.S. Stock Price Index, natural log scale. Dotted (right scale) -- EPS on MSCI Emerging Country Stock Price Index, natural log scale. 4
Exhibit 3: Sales Chart 7 Trailing 12-month sales per share* U.S. vs. rest of the world Solid (left scale) -- SPS on MSCI U.S. Stock Price Index, natural log scale. Dotted (right scale) -- SPS on MSCI World Free ex U.S. Stock Price Index, natural log scale. Chart 8 Trailing 12-month sales per share* U.S. vs. rest of the developed world Solid (left scale) -- SPC on MSCI U.S. Stock Price Index, natural log scale. Dotted (right scale) -- SPS on MSCI Developed Country World Free ex U.S. Stock Price Index, natural log scale. Chart 9 U.S. vs. emerging economic world Solid (left scale) -- SPS on MSCI U.S. Stock Price Index, natual log scale. Dotted (right scale) -- SPS on MSCI Emering Country Stock Price Index, natural log scale. 5
U.S. stock market valuations diverge As illustrated in Exhibits 4 and 5, U.S. stock market valuations are becoming rich relative to foreign alternatives. On a price to sales ratio basis, Exhibit 4 shows U.S. stocks have not been as expensive as they are today relative to the rest of the world since the dot-com top in 2000. This valuation divergence has been expanding regularly against both developed and emerging stock markets since 2011. Finally, on an absolute basis, the U.S. price to sales ratio has not been as high as it is today since 2001 while the price to sales ratios among both developed and emerging stock markets have yet to reach their respective peaks at the end of the last recovery in 2007. The price to trailing 12-month earnings ratios shown in Exhibit 5 are more difficult to interpret because of the much greater cyclical volatility experienced by earnings compared to sales performance. However, compared to the rest of the world (Chart 13), the relative U.S. price earnings ratio began this recovery cycle on par with foreign price earnings ratios but has traded to an expanding premium since 2013. As shown, the only time the relative foreign price earnings ratio has been as cheap as it is today in the last 20 years was at the dot-com top in 2000-2001 and briefly again in 2005-2006. As shown in Charts 14 and 15, most of the current relative foreign price earnings undervaluation resides among emerging market stocks. However, while foreign developed stock markets traded at a premium price earnings ratio relative to the U.S. stock market between 2011 until late 2014, they currently trade at a discount valuation. Overall, relative valuations seem to more than fully reflect weaker foreign company fundamentals. U.S. valuations are higher relative to foreign markets despite fundamental U.S. sales and earnings performances which have been far superior. That is, even adjusting for much better fundamental company performances, U.S. stocks still appear rich relative to most foreign stocks. 6
Exhibit 4: Price to sales Chart 10 Price to sales ratio* U.S. vs. rest of the world Solid (left scale) -- P/S Ratio on MSCI U.S. Stock Price Index Dotted (right scale) -- P/S Ratio on MSCI World Free ex U.S. Stock Price Index rate. Chart 11 Price to sales ratio* U.S. vs. rest of developed world Solid (left scale) -- P/S Ratio on MSCI Stock Price Index. Dotted (right scale) -- P/S Ratio on MSCI Developed Country World Free ex U.S. Stock Price Index. Chart 12 Price to sales ratio* U.S. vs. emerging economic world Solid (left scale) -- P/S Ratio on MSCI U.S. Stock Price Index. Dotted (right scale) -- P/S Ratio on MSCI Emerging Country Stock Price Index. 7
Exhibit 5: Price to earnings Chart 13 Price to trailing 12-month earnings ratio* U.S. vs. rest of the world Solid (left scale) -- P/E Ratio on MSCI U.S. Stock Price Index. Dotted (right scale) -- P/E Ratio on MSCI World Free ex U.S. Stock Price Index. Chart 14 Price to trailing 12-month earnings ratio* U.S. vs. rest of developed world Solid (left scale) -- P/E Ratio on MSCI U.S. Stock Price Index. Dotted (right scale) -- P/E Ratio on MSCI Developed World Free ex U.S. Stock Price Index. Chart 15 Price to trailing 12-month earnings ratio* U.S. vs. emerging economic world Solid (left scale) -- P/E Ratio on MSCI U.S. Stock Price Index. Dotted (right scale) -- P/E Ratio on MSCI Emerging Country Stock Pirce Index. 8
Summary and conclusions Compared to the rest of the world, U.S. economic performance, U.S. company fundamentals, and the U.S. stock market have directionally diverged by more in this recovery than in any during the last 20 years. With the U.S. seemingly residing at a new zip code relative to the rest of the world, what does this imply about the future? Perhaps the contemporary global economic recovery will soon end and the large directional divergence between the U.S. and foreign stock markets will not be ameliorated. However, should the current economic recovery persist, for several reasons we expect foreign stock markets to begin closing the gap to the U.S. stock market. First, weak and non-synchronized global economic growth has and continues to benefit U.S. stocks on a relative basis. As long as global economic growth is weak and perceived as vulnerable, the U.S. stock market will likely be favored as a safe haven with better fundamentals and less credit risks. However, a bounce in global economic growth would likely focus investor attention on the diverse position of the U.S. recovery compared to the rest of the world. We expect better economic growth about the globe in the coming year highlighting the fact that the U.S. has reached full employment while virtually no one else has. Improved economic growth is good for most of the rest of the world experiencing slack resource markets with room for considerable fundamental improvements. However, because the U.S. is uniquely near full employment, faster economic growth would likely aggravate cost-push pressures, worsen profit margins, and accelerate the pace of interest rate hikes. Essentially, a global bounce in economic growth would likely highlight the fact that the U.S. resides at a different zip code than the rest of the world. And this realization may prove to be the catalyst which closes the international performance gap relative to the U.S. stock market. A bounce in global economic growth would likely boost most foreign stock markets but would result in a much more conflicted environment for Wall Street. Second, since foreign stock markets have been underperforming the U.S. stock market for years, international stocks are probably significantly underweighted in most portfolios. Should trends turn more favorable for international stocks, more and more portfolios may boost foreign equity allocations. Third, as shown in Exhibits 4 and 5, foreign stock markets have become increasingly attractive on a valuation basis relative to the U.S. stock market. Indeed, because the U.S. stock market has been so popular in recent years, it may be more extended on a risk basis than almost any other global stock market. 9
Fourth, because the U.S. is nearing full employment, an ongoing economic recovery is now likely to produce negative fallout for the U.S. stock market (e.g., wage and cost-push pressures, profit margin erosion, and higher inflation and interest rates which are challenging for price earnings valuations). Conversely, because most foreign economies are not near full employment, unlike in the U.S., continued economic growth will only be good for foreign stock markets. Finally, while policy officials are turning hostile toward stocks in the U.S. (will the U.S. Fed start tightening in December?), most foreign policy officials will likely remain very supportive for stock markets abroad. Should an unexpected recession suddenly hit the global recovery, all stock markets will likely do poorly but U.S. stocks (because of their perceived safe haven status) should hold up better than international stocks. However, if the current global recovery persist for the next few years as we expect, foreign stocks seem likely to finally sustain a period of outperformance relative to the U.S. stock market. Finally, the U.S. earnings cycle is much older compared to foreign economies. U.S. profit margins are near post-war highs and cost-push pressures are likely to intensify. Conversely, because most foreign economic recoveries are still in an earlier phase of the current recovery cycle, companies in foreign stock markets probably have a greater ability to improve fundamental performances during the balance of this recovery. Written by James W. Paulsen, Ph.D. An investment management industry professional since 1983, Jim is nationally recognized for his views on the economy and frequently appears on several CNBC and Bloomberg Television programs, including regular appearances as a guest host on CNBC. BusinessWeek named him Top Economic Forecaster, and BondWeek twice named him Interest Rate Forecaster of the Year. For more than 30 years, Jim has published his own commentary assessing economic and market trends through his newsletter, Economic and Market Perspective, which was named one of 101 Things Every Investor Should Know by Money magazine. Wells Fargo Asset Management (WFAM) is a trade name used by the asset management businesses of Wells Fargo & Company. WFAM includes Affiliated Managers (Galliard Capital Management, Inc.; Golden Capital Management, LLC; Nelson Capital Management; Peregrine Capital Management; and The Rock Creek Group); Wells Capital Management, Inc. (Metropolitan West Capital Management, LLC; First International Advisors, LLC; and ECM Asset Management Ltd.); Wells Fargo Funds Distributor, LLC; Wells Fargo Asset Management Luxembourg S.A.; and Wells Fargo Funds Management, LLC. Wells Capital Management (WellsCap) is a registered investment adviser and a wholly owned subsidiary of Wells Fargo Bank, N.A. WellsCap provides investment management services for a variety of institutions. The views expressed are those of the author at the time of writing and are subject to change. This material has been distributed for educational/informational purposes only, and should not be considered as investment advice or a recommendation for any particular security, strategy or investment product. The material is based upon information we consider reliable, but its accuracy and completeness cannot be guaranteed. Past performance is not a guarantee of future returns. As with any investment vehicle, there is a potential for profit as well as the possibility of loss. For additional information on Wells Capital Management and its advisory services, please view our web site at www.wellscap.com, or refer to our Form ADV Part II, which is available upon request by calling 415.396.8000. 10