Valuation is a key determinant of an assets future return and risk overpay and returns will likely be lower, but finding value can lead to superior returns and a margin of safety that lessens risk of loss.
Market performance in recent years has been dominated by assets classes with higher valuations and price momentum, such as the S&P 500, REITS, long-term treasuries, and utilities.
The chart (top right) illustrates the price/sales ratio of the S&P 500 relative to the MSCI EAFE (foreign developed market stocks) and MSCI Emerging Markets Index. The price/sales ratio of these two foreign indices is roughly 43% below that of the S&P 500, suggesting superior longer-term return potential. In 2014, however, foreign developed stocks and emerging market equities have returned -4.7% and -4% respectively, versus 10.5% gain for the U.S. market.
REITS are another example of an overvalued asset class topping the performance leaderboards. The S&P REIT Index has risen 23.8% this year, despite a price/sales ratio equivalent to levels seen during the real estate bubble in the mid 2000s.
While valuation is a key driver of future returns, it is not necessarily the best timing indicator. As a result, investors allocated to undervalued sectors, such as foreign developed and emerging markets, must maintain a level of patience until valuations relationships normalize.