The twin headwinds of political uncertainty and growth at levels below population growth in South Africa have contributed to an escalating demand for offshore investment advice.
In the last three years or so, many advisors have done well by proposing that clients should invest in the United States. But breaks in upward momentum of the MSCI North America in January 2018 and again at the end of October 2018 could be signs of further volatility to come. At the same time the MSCI Emerging Markets (measured in US$) is currently at levels last seen in March 2017.
Should new money still be allocated to the US? At Rosebank Wealth Group we are often asked this question. Our standard response is that investors should be constantly mindful of valuation and market risk and should diversify portfolios across countries, risk strategies, investment managers and asset types.
Readers should note that we almost always use third party managers to manage clients’ funds, rather than investing ourselves or simply picking country indices. But like other advisors, we keep a close eye on a wide range of indicators in order to best understand the source of current and future investment returns. Popular ratios include the price to earnings ratio, the market value to sales ratio, and when comparing opportunities across different countries, the market value to inflation-adjusted earnings.
From time to time, our clients ask us for our view on the widely-followed ‘market value to gross domestic product (GDP) ratio’, known as the Buffett Indicator (BI). According to Buffett the BI is ‘probably the best single measure of where valuations stand at any given moment.’ The underlying assumption of the BI is that over the long-term, corporate earnings should remain constant in proportion to GDP. However, Buffett himself warned against using the BI in isolation, saying it had ‘… certain limitations in telling you what you need to know.’
Ideally, the BI should be calculated on a monthly basis over a long-term period. Investors can then evaluate the current BI relative to both the average and over the long-term. The ratio can also help investors identify under- or overvalued sectors within the economy.
Buffett’s rule of thumb is that if the BI in the US is below 50% of the GDP, it is undervalued and offers buying opportunities. If the ratio falls between 75% and 90%, the market is about right. Above 115%, it is overvalued on a relative basis.
At the deep point of the 2008 recession, the ratio was 56.8% while according to an article by John Engel, published by Guru Focus, on October 16th 2018 it was 138.1%. The all-time-high of the BI in the period between 1980 and the present was 148.5 in December 1999. A high and increasing BI is a signal that share prices have increased ahead of the economy and that a correction could be round the corner.
As Buffett noted, the BI has limitations. For the BI to give the cleanest result, the underlying components, structure, regulatory environment and applicable corporate tax rates should be constant. Changes in any one of these factors should prompt analysts to adjust their interpretations of the data.
For example, in the US, the BI should be interpreted against a backdrop of growing numbers of foreign companies listing in the US since 2010. Even though the US economy is so big, the impact of dual-listed firms, like the Chinese multinational Alibaba Group, for example, could skew the BI.
Problems when comparing the BI’s of different countries
There are a number of factors which make intra-country BI comparisons problematic. The main one is that good-quality, long-term statistics are vital when calculating a BI ratio. The World Bank only has GDP and market cap statistics for nine countries from 1975, and data from a further 25 countries from 1997. The BI is most useful when comparing countries where the market structure is efficient and has remained constant for a number of decades.
Further, the BI ratio assumes that the stock market as a whole is a proxy for market participation. However, not all countries have a tradition of raising capital through stock exchanges and have a greater number of unlisted businesses. On the other end of the scale, some business-friendly ‘safe havens’ like Hong Kong, Switzerland and Singapore have market caps that dwarf their GDP.
Thirdly, when comparing value in different countries, the BI ignores critical factors such as the inflation outlook, currency exchange rates and socio-political risk factors.
Despite these qualifiers, current BI ratios as well as other market valuation ratios suggest that emerging markets are attractive, compared with over-priced US equities. In particular, there is an argument that long-only investors should consider investments into China, Russia, Brazil and India. In recent weeks investment firm PIMCO released a statement which said that while the firm’s cyclical outlook was cautious, it was more positive about emerging markets ex China. The firm predicted recoveries in Russia and Brazil and growth in Mexico and India.
We prefer to take a more nuanced view of this outlook. In our view it is important to remember that good value/quality investments in a poorly-performing economy can outperform over-priced investments in a booming economy. We also favour investing in those countries where shareholders’ rights are respected.