ETF Expert Corner

WisdomTree’s Jeremy Schwartz Discusses Global Stock Valuations, International ETFs

August 15th, 2017 by ETF Store Staff

Jeremy Schwartz, Director of Research at WisdomTree, goes in-depth on global stock valuations and highlights several emerging market and developed international WisdomTree ETFs.



Transcript

You can listen to our interview with Jeremy Schwartz by using the above media player or enjoy a full transcription of the interview below.

Nate Geraci: I'm now very pleased to have joining us on the program, Jeremy Schwartz, Director of Research at WisdomTree. WisdomTree is a top 10 ETF provider and as I mentioned earlier, Jeremy is simply a tremendous all-around resource on the financial markets. As a matter of fact, Jeremy actually hosts his own radio program on Wharton Business Radio on Sirius XM - it's called "Behind the Markets." He hosts that with renowned economic and market expert, Professor Siegel. But Jeremy is well-schooled in both the financial markets and certainly ETFs and we're very happy to have him joining us via phone today from London, where he's currently traveling on business. Jeremy, as always, great to have you on the program.

Jeremy Schwartz: Nate, thanks for having me.

Nate Geraci: Jeremy, our focus today is going to be on international stocks, but I thought we might first start by briefly touching on US stocks. In our first segment, Jason and I mentioned that while valuation metrics are rather poor market timing tools, they are pretty good indicators on the probability of future returns and right now US stocks are valued on the higher side. I'm curious, what's your overall assessment of US stocks and are you concerned at all about valuations?

Jeremy Schwartz: Well, it's very important to connect your average valuations of the market with some of the long-term forward looking real returns. I've worked with Professor Siegel for 15 years now and he always likes to point out when he goes to his long-term studies, stocks for the long run, it's a 200-year data set that says stocks’ real return has been 6.5% over these long-term time periods. Bond real returns in the US have been around 3.5% over long-term periods. So you have this 3% equity premium. Now, where do we get 6.5% as a long-term real return? There's a very important relationship with the P/E ratio, which over long periods of time has averaged 15. So if you do 1 divided by 15 you get that 6.5% as your after inflation real return for the market. So where are you on P/E ratios today? I see an S&P 500 P/E ratio of approximately 20, which gives you an earnings yield of 5. So a 5% real return, you add 2% for inflation - maybe gives you a 7% nominal return over longer periods, call it a 5 to 10 year forward looking horizon. What is more expensive, I think, is actually the bond yields where if you go back 200 years, 3.5% was your average real return. Today, the 10-year TIPS bond only yields 50 basis points. So you have a 3% below your long-term average bond return when stocks, below their average return, maybe 1.5% below their normal return. So it's really bonds that are much more expensive than stocks, but that's that whole search for yield, given that there's really not a lot of alternatives out there, that is one of the reasons why pressuring up US stock valuations.

Nate Geraci: Jeremy, putting valuations aside, what keeps you up at night as you think about the US market? Is it geopolitical risk? Is it concerns over what the Trump administration may or may not be able to get accomplished? Is it whether earnings growth can continue? What gives you the most heartburn?

Jeremy Schwartz: I think those are the three major things that are impacting the market today. You hit on all of them. I think last year, at the end of the year, there were prospects for tax reform, people thought Trump would be a positive for lowering corporate tax rates. We haven't seen any action there. I still think people are discounting that the Republicans will get their act together and there's probably not a lot of expectations for them to do that today, given they haven't really accomplished a lot yet. If all of those prospects completely disappeared and you didn't get any tax reform, that would be one of the big disappointments, but the thing supporting the markets has been earnings growth this year. Now, where did that earnings growth come from? Two or three years ago, we were having a very strong dollar environment and that has been a headwind for US earnings. We have a lot of our earnings, half of our earnings really come from abroad. And so this year, you're seeing the reverse side of that. A weak dollar has helped a lot of the US earnings and so that's one of the things leading to positive earnings surprises. So I think you definitely need earnings to stay in there. It would be very helpful if you had tax reform. You've seen regulations being cut and that's very positive for small cap companies, which have really been underperforming on the strong dollar and we haven't seen the corporate tax reform yet. But you really do want to see the Republicans move along corporate tax reform. That's been one of the things that the market was very positive on at the end of last year and I'm hoping that they do get their act together towards the end of this year.

Nate Geraci: Our guest today is Jeremy Schwartz, Director of Research at WisdomTree. Jeremy, let's now pivot to international stocks and going back to valuations, on a relative basis, international stocks do appear to be more attractively valued right now - in particular, emerging market stocks. As a matter of fact, I saw in a recent blog post at wisdomtree.com, over the past 20 years, there have been 61 instances where the valuation gap between the MSCI Emerging Markets Index and the S&P 500 has been as large as where it currently stands, obviously with the S&P valued on the high side. In 54 of those instances, emerging markets outperformed the S&P 500 over the next five years and pretty significantly so. What's your take on emerging markets right now?

Jeremy Schwartz: You know, I think you hit on the valuation case. I think when you look around the world, the lowest P/E ratios we have on any index could be found in the emerging markets today. We have a High Dividend Emerging Markets Index, and the P/E ratios on that basket are about 10 times earnings. We talk about the 20 times earnings on the S&P 500, this has a 10 times P/E ratio, so a 10% earnings yield. A 5% dividend yield on the underlying stocks. Now, when you go to emerging markets, you do have higher levels of risk. You do have currency risk, you do have commodity orientation. You'll have countries that are in the news all the time like Russia that'll become big parts of your basket into these strategies. So it definitely does not come with the same level of risk as a US market index, but if you want to try to find where are you being rewarded or where are the valuations are low, that High Dividend Emerging Markets Index is really one of the better places to find those type of valuation opportunities.

Nate Geraci: Jeremy you mentioned potentially higher levels of risk and certainly in individual countries like Russia. How should investors approach emerging markets? Is it better to hold broad-based emerging market ETFs or should investors target individual country ETFs or is it a combination of the two? What do you think the best approach is?

Jeremy Schwartz: It really comes down to style preferences and what you're trying to achieve. I think when you think about what the typical investor profile looks like, most people have this home country bias where they'll be 80% or more in the US. With a globally diversified market portfolio - you could just buy one ETF or one strategy and basically buy the world. That would have approximately 50% in the US, 50% outside the US and call it a little bit less than 10% in emerging markets. So you can be very simply allocated with just one ETF to cover the world. Or, you can say I want to overweight certain regions. I want to overweight countries or I want to have a certain style tilt when I go towards these strategies. If you're looking at a country level, I think as a long-term, one of the better stories for emerging markets from a demographic perspective you say, "I want the growth profile of these young people around the world - where are they doing the most interesting things around the world?” India is one country that stands out. We have a fund, EPI, that's the broadest way of getting exposure to India. Real local economy, not just exporting to the world. It's really focused on local consumption and they have a Prime Minister Modi who is doing a lot of things from a technology perspective that's really leap-frogged a lot of where we are in the US, where you can open a bank account with your finger print. You get your medical records with a finger print. They're going towards getting rid of cash in their society as a way to get rid of corruption. It's a really forward-thinking economy there. So if I had to say you're picking one country for the next five years in emerging markets, I think India is really one that would stand out. But a lot of people don't want to do just countries and they want to have a broad diversified strategy and that's where I think you look at either a value-oriented strategy with our high dividend approach, or something that just gives you very differentiated exposure to the emerging markets.

Jason Lank: Jeremy, this is Jason Lank. I'd like to talk to you about one of the challenges out there for investing internationally for portfolio managers like WisdomTree and that's the subject of capital controls – and, certainly, China comes to mind with different share classes, investing through Hong Kong versus mainland and where the government will freely intervene in currency or capital markets. As an investor, what are some of the challenges there and what can be done about that?

Jeremy Schwartz: You bring up a very interesting point because in the news this morning, and it's specifically with respect to China, the state has been involved in a lot of the companies and they're large shareholders in a lot of the companies - and the banks in particular - but really throughout the Chinese economy and the state has actually been getting more involved in some of the Hong Kong companies and people worry, “Is the state going to run these companies for shareholders’ interests or for the government's interests?”. And that did lead to a discussion as we were looking at just China and just emerging markets generally, in addition to value factors like a dividend yield or a P/E ratio, we did create this series of indexes that would remove state ownership and you can think of this as an ESG index focusing on the G in ESG, the governance angle of trying to just focus on non-state ownership. An example like China, where more than half the market if you look at a traditional cap weighted index, you could get 70% or more in state run banks and energy companies. When you remove those banks and energy companies, you really get the future of China, the Alibaba's, the Tencent’s of the world that are really tech and consumer oriented. So you get a really different look and feel for what the Chinese economy looks like. So if I'm saying for a long run exposure, China, I think certainly my preference would be this ex-state ownership route, but you can also apply it to a broad emerging market basket as well. So it's really the opposite of a value strategy. They're going to have higher valuations because it's really more tech and consumer oriented than something like the high dividend strategy I talked about before. But they're both I think really good long run ways of getting access to emerging markets.

Nate Geraci: Jeremy, let's talk a little bit more about that because in terms of broad emerging market strategies, as you've mentioned, WisdomTree does offer a number of options, both on the style tilt side, as well as unique ways of accessing emerging market stocks ex-state owned enterprises. You have a very popular dividend weighted ETF, the WisdomTree Emerging Markets High Dividend ETF, ticker DEM. There is the WisdomTree Emerging Markets Ex-State Owned Enterprise ETF, ticker symbol XSOE. There's a Quality Dividend Growth ETF, DGRE. From a retail investor's perspective, what are some of the key considerations in determining the right strategy? Because I do think it can be a bit confusing.

Jeremy Schwartz: No, this is absolutely why I think a lot of individuals, even though you can say the ETF makes and democratizes this idea and brings it out to the masses, there's still a lot of need for a financial advisor to come in and help people structure portfolios and figure out where in these worlds do people want to be invested. So, that's absolutely something that we see a lot of people use advisors to help them make these type of decisions. When I think about the long run merits of both strategies and really high dividends in some ways is the opposite side of state-owned today and sort of ex-state owned. Ex-state owned will tilt you toward this longer-term consumer and technology trend, versus DEM - the high dividend strategy - is really a value strategy, really a deep value strategy and you will get more Chinese financials. You will get more energy companies. And the long-term research, the academics, has said value has been one of the best consistent long-term strategies over the last 50 years. Professor Siegel has done a lot of work on high dividend yield sorts of the market. We do believe in value investing for the long run. But if you're thinking about also these long-term trends, the growth of the EM consumer is an important one, and so this technology shift that we're seeing in the US - you see it with the Amazons and Facebooks and all these tech companies - applying that toward the emerging markets gets you into ex-state ownership type strategies. So I think those are the two real opposite sides of the market today. Whether you want a sort of deeper value, just buy me the cheapest part of the world, the cheapest parts of the world today is DEM. If you say I want that long-term orientation with the growth of the middle class, the growth of the technology area within china, within India and all these other countries, I think the ex-state ownership theme is actually a very good one.

Nate Geraci: Our guest today is Jeremy Schwartz, Director of Research at WisdomTree. Jeremy, I want to make sure we spend at least a few minutes on developed international stocks as well, in particular Europe and Japan. Valuations maybe aren't quite as attractive here as in emerging markets, but they are cheaper than US stocks and performance has been pretty good overall this year. Are you positive on both of these areas and are they more attractive than the US right now?

Jeremy Schwartz: Well, if you go back to my opening model, the stock versus bond model, and we had a 5% earnings yield on the S&P 500 and, call it the 10-year TIPS is 50 basis points, that our nominal bond is say 2.25%, so you have about a 275 nominal yield advantage. If you go to Japan, the Fed is starting to normalize its balance sheet, whatever that means, but they're going to start to let their balance sheet run down from $4.5 trillion. The Bank of Japan is going to be by far the outlier. They said we're going to cap our 10-year bond at zero and I think they're going to be the last to normalize their balance sheet. So if you look at their 10-year bond at zero, our 10-year bond at 220, the P/E ratio on our Japan Index, our sort of flagship exporters oriented index, has a 12 to 13 P/E. So you're getting an 8% earnings yield and so that gap is 8%, because their 10-year bond is zero. So that gap is well more than double the earnings equity premium in the US. So from that stock versus bond model, I'd say Japan is actually perhaps the most attractive market in the marketplace today. Now, that's obviously going to be very tied to global growth, very tied to the US. It's very tied to China, very tied to what the Yen does and what interest rates do, so it's not for the faint of heart. Japan comes with a higher degree of risk than, say, the US. But from the valuation perspective, I do think it is one of the more interesting places. Europe is in between. In Europe, you get about 15 P/E, so call it 6% earnings yield. Germany's 10-year bond yields are negative, so again you're going to get double the equity premium over on stocks versus bonds compared to the US, so again I think you would say German or just the broad European indexes are attractive versus bonds, and so on a valuations basis certainly versus the US as well.

Nate Geraci: Jeremy, WisdomTree's two largest ETFs actually cover Europe and Japan - the Europe Hedged Equity ETF, HEDJ, and the Japan Hedged Equity ETF, DXJ, these both hold dividend paying companies with an exporting tilt, but they hedge against a decline in the Euro and Yen, respectively. The US dollar has weakened this year, so the hedge has been a bit of a headwind in terms of performance. Can you talk a little bit more about these two ETFs and what should the decision-making process be for an investor between currency hedged and unhedged?

Jeremy Schwartz: This is one of the first things we, as an ETF provider, we were the first firm to start talking about currency hedging and I've been writing recently that I think currency hedging has a branding problem that we can't go back and change history. We can't re-label funds. But if I used to call your international equity fund your international double-decker fund, which is your stock plus currency fund, how many people really want the stock plus currency fund? Would you really want that as your default? My hypothesis is that people wouldn't buy the double-decker fund. They'd buy the single-decker fund. They'd buy the stocks. The question is why should you always be long the Euro? Why should you always be long the Yen? There's no model to me that says the Euro is always going to go up in value or that the Yen is always going to go up in value. Sometimes it will, sometimes it won't. The three years preceding this year, we had a strong dollar environment. This year we have a weak dollar environment. To me, you shouldn't be unhedged all the time - that's the one thing you shouldn't be doing. Perhaps you could argue for fully hedging a broader national basket. That will help you lower volatility on a broader national basis. Our newest innovation, about a year and a half ago, we launched a dynamically hedged index and we launched this in five different regions, but our broad-based international DDWM, so Dynamic DWM is our latest. That's really a broad EAFE-like universe for the full developed world and that's gaining a lot of traction. But that will adjust the hedge ratios once a month, based on a currency factor model looking at things like the trending currencies, the momentum, the valuation of currencies and then a carry factor, the interest rate differential. And that dynamic factor model we believe will add value over being hedged and unhedged together and so say roughly that model is 50/50, but it'll range from a low of being hedged on 1/3 on the Euro, a high on the Yen and a half hedge on the Pound – so those are the three big currencies. But that will adjust once a month based on that three factor model and hopefully that becomes a smart hedging program that will help people do it for them. But the one thing I encourage people, the only thing I’d say you shouldn't be is unhedged all the time. And, hopefully, there are dynamic hedging or the fully hedged to help lower volatility is one of the things to think about.

Jason Lank: Jeremy, certainly WisdomTree is a thought leader in the currency and hedging space. Let me throw you a curve ball and that curve ball is Bitcoin. Bitcoin's been called the next crypto-currency, a mode of exchange and investment, all kinds of things, and it's hard to get your head around. But is it possible we see Bitcoin in a hedging strategy? Just high level - your thoughts on that.

Jeremy Schwartz: Yeah, I mean I think there's been indexes. One index I've seen and there's probably some funds out there that might track this - like a gold hedged S&P 500 fund - which is one way. To the extent that people start buying things in Bitcoin, you could say perhaps whether they have a raw, pure bitcoin, just exposure to the Bitcoin – and we do have currency funds, raw exposure to currencies - and to the extent that Bitcoin is another currency, whether it's like the Euro, the Yen or some people think of gold as a currency, yes, I think people will have those. Whether or not you will want to hedge an index – it’s really not a hedge per se - it's really what I would call the double-decker fund where it's giving you exposure to an asset class, plus the Bitcoin return. So it's all how you frame it, but we'll have to see how that market develops and see if that becomes a more meaningful thing for people.

Nate Geraci: Jeremy, we have about two minutes left here - before we let you go – occasionally, we'll hear some investors question the value of owning international stocks in a portfolio and we tend to hear two main pushbacks. The first is that large cap US companies are so global in nature now, they drive such a large portion of revenue and earnings overseas, they're effectively proxies for international exposure. And then the second is that the global economy is so interconnected now that if US stocks tank or we have a recession, international stocks are going to be negatively impacted as well - they're essentially tied together at the hip, so what's the point of owning them? How would you address those two concerns?

Jeremy Schwartz: Well, in a way, one of the concerns and it's interesting, Jack Bogel, one of the founders of Vanguard always said “I only buy the US” and one of his first lines in talking about that is, “Well you consume in dollars, you don't need these foreign currencies”. So hey Jack, we created something that you don't need to take this foreign currency risk. Your assets and liabilities are mashed together. You only have US dollar risk when you hedge the currency. So that was one of his objections, which I think is very easily overcome-able today. But just like you wouldn't say, well I'm going to sort the S&P 500 and buy companies that start with the letter A to M, why am I going to sort the world and say I'm just going to buy half the market. You are missing half the market out there and, yes, there are times when the S&P outperforms the rest of the world. The last decade is such a time. But that's also why probably now is the time you need to look at international the most - is when they've underperformed by so much. It perhaps is a time to consider them even more because the valuations have improved and valuations are critically tied to future returns. So I'd say I hear that concern and you do get global footprints from US companies, it's absolutely true. But you buy a European company, it has footprints to the US, it has footprints to the emerging markets. You buy Japan and I actually think a lot of the Japanese multi-nationals, Toyotas, it's more about the US than it is Japan and so you can even get back to the US exposure from these foreign companies. So I just say, “Why make a big bet on the US outperforming the rest of the world?”. That may not always be the case.

Nate Geraci: Jeremy, with that, we'll have to leave it there. As always, just a pleasure having you on the program. We greatly appreciate your time today and safe travels back to the US. Thank you.

Jeremy Schwartz: Thank you. Pleasure being with you guys.

Nate Geraci: That was Jeremy Schwartz, Director of Research at WisdomTree and you can learn more about the WisdomTree ETF lineup by visiting wisdomtree.com.