When Cheap Doesn’t Mean Value

With the bull turning six, folks are starting to wonder: Which stocks are best for the rest? Some suggest late-bull success requires ditching expensive stocks and buying what's cheap. Sounds sensible! But this overlooks a crucial point: Valuations don't predict performance.

Contrary to popular belief, high valuations aren't a ceiling on prices. We understand why this myth persists: You buy a stock because you want a piece of a company's future earnings. It seems logical to compare the share price and earnings to determine whether it's over, under or fairly valued-and whether it has room to rise. But if high price-to-earnings (P/E) ratios were predictive, history would prove it. Stocks would always do worse in high-P/E environments than when P/Es are low. But this isn't so! During the 1990s bull market, for example, P/Es climbed far higher than today's levels as investors' attitudes toward the future warmed and eventually became downright giddy. Between February 8, 1996-when the S&P 500's forward P/E first hit levels matching today's-and that bull's end in March 2000, the S&P 500 rose 149%.^[i]

On the flip side, low valuations don't automatically foretell robust returns. Yes, low P/Es imply stocks are "undervalued," suggesting it's only a matter of time before what went down shoots back up. But before you rush headlong into cheap countries like Greece and Russia, some perspective is in order-just because something is "cheap" now doesn't mean it can't get cheaper. At the end of April 2010, as Greece's economic implosion was just starting, the MSCI Greece's forward 12-month P/E was a low-low 8.2.^[ii] A year later, Greek stocks were down 30% and the 12-Month forward P/E had slipped to 8.1.^[iii] In the next year, Greek stocks fell 60% and got even cheaper.^[iv] Today the MSCI Greece's forward P/E is 10.9.^[v] Pricier! If a cheaper Greece can fall dramatically, why would today's valuation be any more bullish? Russia? Same story. Today the MSCI Russia's 12-Month forward P/E is 5.2^[vi]-similar to the beginning of 2014. For investors who think Russia looks "cheap" now, consider last year. The MSCI Russia's forward P/E fell to 3.9^[vii] in mid-March as escalations with Ukraine intensified. After hovering in the mid-4s for most of the year, the P/E dropped to 3.1^[viii] in December after the Russian ruble's plunge. For the year, Russian stocks declined 46%.^[ix]

In both cases, what's to say today's low valuations represent the final sale price? After all, Greece is still Greece-it has struggled mightily throughout the current expansion, and its drama shows no signs of abating. Likewise, Russia's one-trick economy depends on energy prices, and oil's decline makes a nasty recession this year near-certain. Russia is also subject to the unpredictable whims of "President" Vladimir Putin, and its biggest firms are presently cut off from international capital markets. Sometimes low P/Es are irrational, but sometimes they are very rational indeed. You can't discern between the two based on the number alone. You must look deeper.

Trying to uncover cheap stocks is a value approach-a style of investing. Sometimes, value works great! But no style is permanently best, and growth stocks have their time to shine, too. Value stocks tend to do better earlier in bull markets, when sentiment is trashed. Maturing bull markets usually favor higher-valuation growth stocks, as late entrants gravitate toward blue chips or firms they see as having a brighter future. Looking for the bargain-basement value play in a bull's second half is typically not the winningest move, and all signs indicate this bull is in its more mature stages. Growth stocks aren't nearly as popular with pundits as value right now, but that's often a good sign. What's unpopular usually does better looking ahead-its opportunities are less discussed and therefore less likely to be discounted. Given how widely discussed supposed value opportunities are today, it's hard to imagine markets haven't already priced in most of that discussion.

While valuations can help you gauge sentiment, this doesn't work the way most recent coverage implies. Comparing higher valuations in the US and UK with lower valuations elsewhere and concluding sentiment is overheated in the English-speaking world and too low everywhere else is too myopic. Some countries consistently trade at a discount-Korea, for example. Sentiment toward Korea isn't permanently dour, it just means investors, for whatever reason, put less of a premium on Korean earnings regardless of their mood.^[x] Tracking an individual index's P/E over time is a more accurate way to measure sentiment. Seeing how P/Es today compare with past cycles can help you discern whether sentiment is too depressed, too gung-ho or middling. This is as much about the rate of change as it is the level.

Other sentiment indicators underscore what this chart suggests-valuations in the US, UK and core eurozone aren't out of whack. Headlines are still plenty pessimistic, confidence surveys are bouncy, and plenty of good news goes unreported. Until that changes and true euphoria reigns, there will be plenty of opportunities in these regions, even with valuations higher than other locales.