Yes, markets have beaten up everyone so far this year. Investors are looking for answers and struggling to identify a culprit -- just read the headlines. According to my Bloomberg colleagues, some observers are even beginning to wonder whether a repeat of the nightmarish 2008 meltdown is underway.
All of this sudden soul-searching is odd. Overseas markets have been in turmoil for much of the last two years. The MSCI EAFE Index returned a negative 4.5 percent to investors in 2014 and a negative 0.4 percent in 2015. The MSCI Emerging Markets Index returned a negative 1.8 percent and a negative 14.6 percent, respectively, over the same period.
There hasn’t been much confusion over the declines overseas, and for good reason: the troubles are well known. China is slowing and a hard landing is not out of the question. Europe is struggling to stimulate growth. Geopolitical tensions are high. Energy prices have collapsed, devastating regions that are heavily dependent on energy production and export. Overseas markets have repriced to reflect these risks.
There is one recent and significant change: U.S. markets are now in the process of repricing, too. Until this year, the U.S. had thrived while investors took a wary view of overseas markets. The S&P 500 Index returned 13.7 percent to investors in 2014 and 1.4 percent in 2015. Investors seemed to view the U.S. as an island of prosperity, unaffected by overseas risks, but in a globalized economy thinking that way is a fantasy.
What is surprising, then, is not that U.S. markets have finally woken up to reality, but that it has taken this long. The move thus far has not been as dramatic as it may seem. At the end of 2015, the normalized price-to-earnings ratio for the S&P 500 Index was 21.8 (calculated using ten-year trailing average earnings, excluding negatives). The normalized P/E ratio has since contracted to 20.
At that valuation, the S&P 500 Index is still 61 percent more expensive than the MSCI EAFE Index and 131 percent more expensive than the MSCI Emerging Markets Index. Are we prepared to say that this accurately reflects the relative risks to the U.S. versus overseas markets? Yeah, okay, count me out.
So the U.S. is in a long overdue and perfectly healthy process of repricing risk –- one that is already in late innings overseas. It is not, repeat IT IS NOT, a foretelling of financial crisis 2.0, as some well-known money mavens would have you believe. In September of last year Carl Icahn proclaimed in a self-made video that the public “got screwed” in 2008 and will “get screwed again,” implying that another crisis is in the offing. Earlier this month, George Soros declared that global markets face a crisis similar to 2008.
It’s not that a systemic breakdown like the 2008 financial crisis is ever out of the question, but that the potential for mayhem is far less today precisely because global markets largely already reflect investors’ fears. That's exactly how valuations are meant to function -- even when they function imperfectly.
Consider that in October 2007, the normalized P/E ratio for the S&P 500 Index was 25.0; the normalized P/E ratio for the MSCI EAFE Index was 27.0; and the normalized P/E ratio for the MSCI Emerging Markets Index was 28.6. It’s difficult to paint a more euphoric -- and self-deluded -- picture. By the time the dust settled in February 2009, those same P/E ratios were 11.1, 10.4 and 10.2, respectively. On an equal-weighted basis, that represents a valuation contraction of 60 percent across the three indices.
Now consider that those same P/E ratios today are 20.0, 12.4 and 8.7, respectively. That's not a picture of a world gone mad. (And yes, emerging markets are cheaper today than at the most desperate hours of the financial crisis!)
On an equal-weighted basis, a net valuation contraction of only 14 percent across the three indices would be required to reach the trough levels of the financial crisis in February 2009 (and emerging market valuations would actually have to climb from where they are now to get back to that bottom).
Granted, a 14 percent valuation contraction on top of the declines already suffered this year is no picnic, but it would resemble a normal cyclical correction more than a once-in-a-generation crisis.
Let’s allow U.S. markets to find more appropriate levels, just as overseas markets have done, without fearing a cataclysmic end. This is not 2008.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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Nir Kaissar in New York at firstname.lastname@example.org
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