US, Germany, Japan: Post Brexit

June 24, 2016

Before the Brexit vote and market turmoil I was privileged to share interview time on the “The Larry Kudlow Show,” hosted by Larry Kudlow, with a longtime friend, Jeff Kleintop of Schwab. Larry, Jeff, and I have had many discussions about markets and economics over the years. In addition to discussing the pros and cons of Brexit, during this interview, I compared the valuations of three major markets: the United States, Japan, and Germany. For those who may have missed “The Larry Kudlow Show” on June 18, 2016, here is a recap. I am also including some explanatory notes. If you would like to listen to our conversation, you can find it here: Our segment begins at the 58-minute mark.

The United States: SPY

The United States is the largest capital market and economy in the world. Its benchmark references the Standard & Poor’s 500 Index (S&P 500) and is represented by SPY, the first ETF, launched in 1993. It has been a remarkable success. With its low expense ratio, SPY captures the movement and activity of the S&P 500 within a few basis points (bps). The index itself is managed by State Street Global Advisors and represents large-capitalization stocks in the US. SPY has a market capitalization of about $180 billion, sees a very large trading volume every day, and usually trades within pennies of its net asset value.

Bloomberg data shows that SPY has had a trailing price-to-earnings (P/E) ratio of 24 over the last year. At Yahoo Finance, SPY shows 18 as its forward P/E estimate. Thus, the outlook for SPY is growth in earnings and an improving P/E ratio. Whether that outlook comes to pass remains to be seen. Improvement from an average P/E ratio of 24 to 18 is a positive indicator for the US economy and its profits.

Note that SPY is capitalization-weighted. The 10 largest weights are Apple Inc. (2.88%), Microsoft Corp. (2.21%), Exxon Mobil Corp. (2.09%), Johnson & Johnson (1.76%), General Electric Co. (1.56%),<> Inc. (1.52%), Berkshire Hathaway Inc. (1.48%), Facebook Inc. (1.45%), AT&T Inc. (1.39%), and JPMorgan Chase & Co. (1.27%). Those holdings drive a considerable portion of the index’s performance. If we do not consider the Google stock split (to form GOOG and GOOGL), then Alphabet Inc. is actually the second largest holding (2.26%).

For reference, we will note that pharmaceuticals constitutes about 7% and banks about 6.5% of the total index. The SPY yield is a little over 2%.

Given SPY’s 2% yield and outlook for a forward P/E ratio of 18, valuing SPY is a difficult task in a climate where the 10-year Treasury yield is about 1.5%. The earnings yield with a forward multiple of 18 is approximately 5.5%.

Thus, the equity risk premium calculation would take the earnings yield (5.5%) and then subtract the 10-year Treasury yield. The difference is an equity risk premium of about 400 bps. In a climate of very low interest rates, low growth, puzzling monetary policy, and questionable robustness within the American economy, a 4% equity risk premium would suggest fair valuation and certainly not a bargain. The Brexit outcome suggests lower interest rates for a longer period with the Fed on hold for a while.

We are going to skip the world’s second-largest economy, China. Its markets are not liquid, deep, or qualified enough to rank among the mature economies or index-eligible global markets.

We are also going to skip the United Kingdom. Brexit issues have induced turmoil, so the calculation of valuation is set aside for the purpose of this writing.

We move forward with the other two major markets.

Japan: EWJ

Japan is the world’s third largest economy and second largest mature equity market. It is represented by the iShares MSCI Japan ETF, EWJ, which captures the basic structure of the Japanese stock market. Within that structure, some sectors, such as pharmaceuticals and banks are quite comparable in size to those same sectors in the US. Pharmaceuticals are almost 7% in the Japanese market, as they are in the US. Banks are slightly over 7% in Japan, also similar to the United States. In other sectors, there are differences. For now, picking these two sectors provides a reference.

The largest holding in EWJ is Toyota Motor Corp. (5.09%), followed by Mitsubishi UFJ Financial Group (2.20%), KDDI Corp. (1.95%), Softbank Group Corp. (1.92%), Japan Tobacco Inc. (1.60%), Honda Motor Co. Ltd. (1.54%), Sumitomo Mitsui Financial Group (1.48%), Mizuho Financial Group Inc. (1.31%), NTT DOCOMO Inc. (1.31%), and Sony Corp. (1.31%).

Japan (EWJ) shows an average trailing P/E ratio of 17. That ratio compares favorably with almost 24 for the United States. The Yahoo Finance estimate of forward P/E is 14 for EWJ. Thus, the earnings yield for the Japanese ETF is estimated at 7%.

The interest rate comparison for Japan is below zero. Post Brexit it is likely to stay below or at zero for many more years. The equity risk premium for Japan, using the riskless government bond interest rate, is higher than the earnings yield and above 700 bps. Truth be told, post-Brexit, there are questions about growth rates in Japan. But worst cases from Brexit are not as devastating as market panic selling has suggested. Japan was cheap before Brexit. The yield is 1.5% and is lower than the 2% in the US.

The list of companies, Sony and Toyota among them, illustrates how cheap Japanese stocks are, compared to US stocks. Their relative value is one reason why Cumberland Advisors’ international accounts continue to maintain an overweight position in the Japanese stock market. Japan’s is perhaps the cheapest major market in the world. EWJ is for sale at bargain-basement prices. It is historically rare for the equity risk premium to be higher than the earnings yield.

There are two possible reasons for this anomaly: (1) the market is fully mispricing outcomes in Japan, or (2) the market is offering investors a bargain that does not come along often. In our view, the right take is the latter, and for that reason we are overweight Japan.

EWJ has a market cap of approximately 15 billion and trades within pennies of net asset value. This holding is easy to execute for the US foreign investor.

Germany: EWG

The world’s fourth largest economy and third major market is Germany, which is represented by the iShares MSCI Germany ETF, EWG. The largest weights in EWG are Bayer AG (7.97%), Siemens AG (7.72%), SAP SE (7.29%), BASF SE (6.78%), Allianz SE (6.52%), Daimler AG (5.88%), Deutsche Telekom AG (5.02%), Fresenius SE & Co (2.78%), Muenchener Rueckver AG (2.75%), and Deutsche Post AG (2.68%). Here, just as in the other two ETF’s, we see a virtual “Who’s Who” of major global companies.

The yield in EWG is approximately 2.4% and is higher to that of SPY. The market cap is the smallest of these three at about $4 trillion. By the way, EWG trades in a liquid form and can be executed within a penny or two of net asset value. The trailing P/E average of EWG is 21, and the forward P/E estimate is 14, just as it is in Japan.

In Europe and in Germany, the 10-year reference for government debt is trading below zero. Brexit ensures it will be there for years. Hence, EWG has the same value characteristics as EWJ. We see this list of companies as cheap. The earnings yield for EWG is above 7%, as it is for EWJ in Japan. That equity risk premium is higher than the earnings yield because of the negative interest rate on the riskless government bond that it is compared to. Pharmaceuticals are 9.2% in the German basket, and banks are approximately 2.8%.

Our conclusion is that the United States, by metrics of valuation, relative valuation, and comparison with riskless government debt, is fairly priced but no bargain. Japan and Germany, by comparison, are cheap. They offer bargains if investors are willing to test the waters. Companies like Toyota and Bayer or Siemens and Sumitomo are major players in the world. They rank as highly as many companies within the S&P 500 Index do. They are strong, heavily capitalized, globally active enterprises. In one place, they are available for an earnings yield above 7%.

Cumberland Advisors continues its positions of overweighting certain international markets. We believe those markets are strong bargains. They are readily available to investors who can participate in very liquid ETFs and access the entire array of stocks within those baskets.


The ideas and opinions expressed in this blog are those of the author, and they should not be perceived as investment advice or as any other kind of advice.

The preceding is a commentary by Cumberland Advisors and has been reposted with permission. Cumberland Advisors commentaries are available at

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