NEW YORK (TheStreet) - U.S. stocks are enjoying their best year since 1995, and whether or not the good times continue into 2014, one thing is clear: domestic equities have become expensive.
The S&P 500 has gained an eye-popping 23.3% in 2013, its best run to start a year since 1997 when the index advanced 26.7%. Those were the halcyon days of the Internet Boom, and we all know how that ended.
The U.S. benchmark currently trades at 15.9 times earnings, its highest level since May 2010, and a point at which BlackRock's (BLK) Russ Koesterich, the firm's global chief investment strategist, marks the group as fully valued.
"The majority of this year's U.S. market gains have come through higher multiples, not a boom in corporate earnings," Koesterich, who is based in New York, said in a phone interview. "Their premium to other markets is starting to look excessive."
Koesterich, who helps oversee more than $4 trillion, urges investors to consider Japan and Europe for more compelling opportunities. U.S. equities, by comparison, have been boosted by the Federal Reserve's stimulus program, producing valuations that are likely to remain high even if the Fed curbs its equity-boosting bond-buying.
More broadly, the U.S. economy is growing at about 2% per year -- a rate that seems to make high valuations hard to justify. Meanwhile, the green-shoots of recovery in Europe and Japan's emergence from decades of deflation, are generating stocks that are undervalued with higher growth potential.
"In Europe, the key is to look for larger companies that have very export-driven sales where valuations have been punished just by being based in Spain, Italy or Germany," he said. "In the UK, the economic recovery is also stronger than people expected."
Koesterich says U.S. stocks trade at about 2.5 times book value - or 2.5 times more than the value of their assets - compared to a ratio of 1.6 times for other developed markets and 1.5 times for emerging markets. The BlackRock strategist says U.S. stocks don't justify this premium. He says U.S. energy and technology stocks still appear reasonably priced but warns domestic shares in general will soon tip into overvalued territory unless earnings growth strengthens.
Europe has become attractive as the eurozone emerged from an 18-month recession in the second quarter with 0.3% growth. At long last, the general consensus is that the region is no longer in crisis, and true to form, investors have already jumped on board: the final week of September saw a record $5 billion in funds flow from US investors to European stockmarkets, according to Bank of America Merrill Lynch and EPFR Global.
Bill Mann, who helps oversee $550 million at Motley Fool Asset Management, backs Koesterich's stock specific approach to Europe - pointing to opportunity in stocks like Nestle, Adidas and other large consumer and luxury brands.
Martin Jansen, head of international equities at ING U.S. Investment Management, likes select European financials, given that banks and lenders should benefit as the region's economies recover from the worst of the sovereign-debt crisis. But Jansen warns that cheap energy and commodity companies may present value traps appearing cheap while failing to offer share price upside. Jansen helps oversee $160 billion in funds.
More broadly, some investors point to greater potential for profit-margin growth in Europe or Japan compared to the U.S., where profit margins are viewed as close to peaking. Matthew Beesley of Henderson Global Investors, who helps oversee $103 billion in funds, emphasizes that European margins are still 2% below their peak.
"I'd make a bet lots of companies will be surprised at their operational leverage immediate profit boost from revenue growth after cost cutting," Beesley, Henderson Global's London-based head of global equities, said in a phone interview.
Stimulus Boost for Land of the Rising Sun
Japan is another region where fund managers see value. "For the next six to twelve months, Bank of Japan stimulus will be a bigger tailwind for their equities than Fed stimulus," Koesterich says, referring to Japan's still-nascent economic recovery compared to the U.S., where stimulus is expected to be reduced sometime next year.
Longer term, Jansen says the world's third-largest economy is just beginning to catch-up to other developed markets after decades of deflation. In addition, he notes that Japanese companies are making more active use of their balance sheets - investing and spending for growth rather than hoarding cash - suggesting further upside for Japan's domestic environment despite the Nikkei's 57% gain over the past 12 months.
Emerging Markets: Still a Risky Play
Emerging markets seem attractively-valued compared to U.S. equities but quality isn't uniform. The MSCI Emerging Markets index has lost 2% in 2013 while the benchmark trades at 12.2 times earnings. Beesley says he remains cautious about jumping into China, India, Indonesia, Turkey and Brazil.
"Many of these economies will see GDP grow less fast and also face some inflation challenges," he said. Beesley adds that countries with large current account deficits that have been by U.S. dollars are vulnerable to sudden hikes in U.S. interest rate. "As dollars are repatriated, either interest rates in their economies will have to rise or their currencies will need to appreciate - neither of which is supportive for growth," Beesley said.
Jansen is similarly cautious, preferring developed markets in the short term. "Growth from Europe and Japan will be more visible and that will feed back to emerging markets," he said. Within developed markets, he points to opportunity in China, Turkey (when looking beyond political instability) and Brazil for its relatively diversified stock market.
Another approach may be picking markets that are essentially developed, but classed as 'emerging' on technicalities. For example, Mann likes Korea, which is classed as emerging due to its difficult access for global investors (such as corporate documents not being translated to English). Yet he notes the country boasts big global brands such as Samsung and Hyundai. Mann also likes Peru, which he views as having undergone significant economic reforms, and a country that is comparatively easy to conduct business in.
Home Bets Persist
Scott Schweighauser of Aurora Investment Management still views U.S. equities as the most attractive option. He points to a benign interest rate backdrop, solid corporate profitability, and opportunities on both the long and short side for investors. "The U.S. is as compelling an environment as you could hope for," says the president and portfolio manager, who helps oversee $9 billion.
But all things considered, the message is clear: U.S. stock valuations have grown and profit margins are close to peaking. If stronger company earnings do not soon justify this year's rally, further gains may be hampered. Instead, investors willing to take a punt abroad face nascent economic recoveries in developed markets such as Japan and Europe.
Ongoing stimulus support in those economies offers further support - just as it has fuelled gains in the S&P 500. Longer term, emerging markets in China, Turkey, Peru and Brazil may also offer gains: otherwise put, now is an opportune time to travel with equity investment.
Written by Jane Searle in New York