Why the U.S. Stock Market is One of the Most Dangerous in the World

Which are the most dangerous markets to investors around the world?

Which countries’ stock markets are most likely to blow up your retirement plan, your kids’ college funds, or your hopes of saving up enough to buy that yacht?

If you think it’s markets such as Russia or Greece, or even China, you may want to think again. According to some fascinating research produced by Wellershoff & Partners, an investment firm in Zurich, Switzerland, the real dangers are in very different places.

Based on data comparing the current valuations of each stock market to its historic averages, Wellershoff comes up with a list of five markets most at risk of producing miserable returns over the next five years — and fourth on that list is the stock market of the United States.

Ireland ranks at the bottom, according to Wellershoff’s calculations. Over the next five years the Irish market is most likely actually to lose investors about 16% of their money, after accounting for inflation. Other markets offering the lowest returns include South Africa, plus the very minor emerging markets of the Philippines and Thailand.

Wellershoff’s estimate for the U.S. is for a total stockholder return between now and 2020, measured in constant dollars, of just 8%. Not 8% a year — 8% overall. The historic average would be a gain of about a third, in constant dollars, over five years.

Before going any further, I need to point out that the future includes so much that’s random that all forecasts need to be taken with pinches of salt. “Never make predictions, especially about the future,” as Casey Stengel, legendary manager of the New York Yankees, once said, and he had a point.

Yet there is a broad gray area between thinking we can predict the future with a lot of accuracy and thinking we are living in a world of total chaos and we can’t predict anything at all. Over the next five years, I’m going to wager that the Februarys will be colder on average than Julys, the sun will rise in the east, and Kim Kardashian won’t be elected Pope. Call me a nut if you will.

Wellershoff’s analysis is not based on sticking a wet finger in the air. Instead it’s based on comparing share prices with average per-share earnings over the course of an extended economic cycle. That’s the methodology for “cyclically-adjusted price-to-earnings” ratios made famous in the U.S. by Yale University Professor and Nobel laureate Robert Shiller. The rationale for this model is to smooth out booms and busts and look at the underlying earnings power of the stocks. Wellershoff then compared today’s cyclical PE for each market with the average cyclical PE.

So, for example, since 1979 Australia’s average cyclical PE is about 18, according to Wellershoff. Today it’s 15. So although the future involves a lot of guesswork, it is reasonable to say that the Australian stock market appears to be cheaper than its average levels over the past 35 years. That may not sound like much, but it’s actually a huge statement.

There is an enormous body of research arguing that a key driver of financial returns — and probably the key driver — is the valuation of a stock or a market when you buy it. Buy cheap, sell dear.

And one of the key factors in the Wellershoff analysis is that it is based on currently observable facts, not on what somebody says Vladimir Putin or Angela Merkel is going to do next month.

Right now, Wellershoff says, the U.S. stock market sells for about 24 times its cyclically-adjusted per-share earnings, compared to an historic average of about 16 times. That is very expensive by historic standards. Shiller himself says the market sells for more than 27 times cyclical PE.

No, this doesn’t mean we should all rush to sell all our U.S. stock funds today and hide under the bed. But there are real, meaningful conclusions that every ordinary investor should draw.

The U.S. market is risky. Investing all or most of your risk capital in U.S. stocks alone, for example through a Standard & Poor’s 500 SPX, -0.20% stock market index fund, is foolish. Those who recommend it are actually recommending that you gamble. Maybe it will work out, maybe it won’t. Damagingly, they are not selling this gamble as a gamble, but as a “safe” and lower-risk strategy.

Financial intermediaries who are recommending this are doing so, in part, because the practice is so widespread that you won’t be able to sue them if it goes wrong.

Most ordinary people want to improve their chances of earning a good return while minimizing their risks of getting hosed.

Wellershoff finds that many or even most overseas markets are either reasonable or a good value by historic standards. Apparent bargains can be found across a broad mix of developed and developing countries, and across multiple continents, from Mexico to France, and from Poland to Hong Kong.

You can include those in your portfolio by investing in “international” (i.e. developed) and “emerging markets” funds alongside your U.S. small-cap and large-cap funds.

Or you can just gamble on one market that looks really expensive, and hope for the best.

About the Writer:
Brett Arends is an award-winning financial columnist with many years experience writing about markets, economics and personal finance. He has received an individual award from the Society of American Business Editors and Writers for his financial writing, and was part of the Boston Herald team that won two others. He has worked as an analyst at McKinsey & Co., and is a Chartered Financial Consultant. His latest book, “Storm Proof Your Money”, was published by John Wiley & Co.

Source: MarketWatch

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