Impact of Profit Margins on Stock Market Valuations

October 30, 2014 | Nat Kellogg, CFA, President

This week’s Chart of the Week looks at U.S. (measured by the S&P 500) and Developed International (measured by the MSCI EAFE) equity market valuations. Over the last five years U.S. equity markets have outperformed their developed market peers by almost 10% on an annualized basis (14% vs. 5.3%). Perhaps most surprising is that, as this week’s chart shows, U.S. markets trade at only a modest premium to other developed market peers (16.5 price to earnings ratio for U.S. stocks versus 14.9 for developed market international stocks). However, non-U.S. stocks are actually much cheaper when normalized for profit margins. Profit margins have a strong tendency to mean revert over time (high profits attract competition which drives down profit margins) and U.S. profit margins, at 9.5%, are at an all-time high. Conversely, non-U.S. developed market profit margins are just 6.6%, below their long-term average. Not since 2009 have international profit margins exceeded U.S. profit margins.¹ Investors should be aware that as profit margins revert to their long-term averages it could leave U.S. stocks looking pricy, and their developed market peers looking cheap.

¹This is shown in the graph when the red area (EAFE profit margins) completely covers the blue area (S&P 500 profit margins).