A bear market is a value restoration process. Assets that had previously been priced for poor returns can again be expected to appreciate handsomely. Not only are prospective returns higher after declines, but risks are lower, as prices are no longer based on fragile narratives about perpetual prosperity. All of the assumptions that justified high multiples and low yields are forgotten, and the new consensus becomes dismissive of optimism. Nonetheless, most businesses adapt to the new environment and find ways to grow again, and investor worry turns to guarded optimism as the numbers improve. Higher prices and greater willingness to invest feed business growth in a virtuous cycle, resulting in gains for those who buck the pessimistic consensus.
Things certainly look bleak from this vantage, but so far in 2020, we have seen a dramatic improvement in the long-term prospects for global equities. The easiest way to track valuations around the world is through the CAPE ratio, which compares stock prices to a 10-year running average of earnings. As you can see below, our 20-country mean CAPE has plummeted from 21 in January to 16 as of the end of April. While valuations have been lower at times, this reset is encouraging for long-term investors.
Long-term PE: US vs Global Mean
The US market is cheaper now than a few months ago, but it remains expensive at a CAPE of 27. The long-term prospects from such a level are poor, even without the likelihood of a contraction in earnings during this recession. Some developed countries are quite cheap already, such as the UK at 14, Hong Kong at 15, and South Korea at 11. Even Japan, long the most expensive market in the world at over 50, is trading at 18 times 10-year earnings. This dispersion in valuations means that it is going to be more important than ever to diversify your equity exposure in the coming years. As countries begin to adapt to the new economic climate, we are likely to see strong bull markets emerge.
For now the trends remain negative in most markets, so momentum-informed portfolios like those we run at my firm are defensively positioned, but by preserving value now we remain ready to act when the smoke clears.