On Wednesday, the respected hedge-fund manager David Tepper, who runs $20 billion at Appaloosa Management, told an investing conference that "the market is kind of dangerous right now.…I'm nervous. I think it's nervous time right now."
That's for sure. The Dow Jones Industrial Average dropped 167 points on Thursday, or 1%, as investors flipped from complacency to anxiety in a heartbeat.
Earlier in the week, stock indexes around the world had marched to new all-time highs: the Dow, the S&P 500, the German DAX, the Argentine and Indian markets, the MSCI World index of 23 developed countries.
Mr. Tepper perfectly captured the worry that lies at the heart of this latest rally in stocks.
If you share his concerns, there's no need to make drastic changes to your stock portfolio, but shifting your focus to markets outside the U.S. in search of better returns is a wise move.
The question on most investors' minds is: Are stocks cheap or expensive? The S&P 500 is trading at an average of 15.3 times what analysts expect the companies to earn over the next year—barely above the typical long-term level of 14.7 times expected earnings, according to Gina Moore and Chris Covington of AJO, a Philadelphia-based investment firm that manages $24 billion.
"But are those earnings expectations too high or too low?" asks Matthew Kamm, who co-manages $22 billion in growth stocks at Artisan Partners in Milwaukee. "There's a fistfight in the market right now trying to figure that out."
In the first quarter, earnings at S&P 500 companies grew 2.1%, compared with the 1.3% decline that analysts expected in March, according to FactSet.
If the U.S. and global economies continue to recover, corporate profits should grow robustly. But if the recovery falters, then high expectations will turn out to have been only hopes—and stocks aren't priced to permit much margin for error if those hopes are shattered.
That is especially true in the U.S.
Most stock markets elsewhere in the developed world are much cheaper than they were at the last market peak in 2007, says Doug Ramsey, chief investment officer at Leuthold Weeden Capital Management in Minneapolis.
In October 2007, the MSCI World ex USA index, which includes 22 developed markets outside the U.S., traded at 27.2 times its average earnings over the previous five years; now it is at 19.2 times the past five years' earnings, according to Mr. Ramsey. The U.S., meanwhile, is back to where it started—coming down to 23.3 times earnings now from its 2007 level of 24.4 times.
The U.S. market is trading at 61% more than its average ratio of price to long-term earnings, adjusted for inflation, according to Amie Ko, an analyst at Research Affiliates, a firm in Newport Beach, Calif., that advises on $169 billion in investment strategies world-wide.
Meanwhile, her data show, 12 major developed and emerging markets, including Brazil, Italy, China and South Korea, are trading for at least 20% less than their historical average on the same measure.
It is important to realize, however, that such numbers are data, not destiny. Common sense and financial history say that stocks will have the highest returns when you buy them at the lowest valuations. But stocks can stay expensive for an amazingly long time, and all your teeth and hair could fall out before stocks finally become an unambiguous bargain again.
Finance professors Elroy Dimson, Paul Marsh and Mike Staunton of London Business School have found that U.S. stocks have done the best—delivering annual returns of 10% and up, after inflation—when investors buy them at less than 14 times their long-term dividends, adjusted for the cost of living.
Unfortunately, the last time stocks were so cheap by that measure was December 1942.
U.S. stocks tend to have done the worst when they trade above 35 times that measure of dividends. And they have been valued at least that richly 92% of the time since the beginning of 1987, according to data from Yale University economist Robert Shiller.
From those levels, according to the London Business School researchers, U.S. stocks have historically delivered average annual returns of 3% to 4%, after inflation, over the ensuing five to 10 years.
So you should certainly expect underwhelming performance over the years to come. On the other hand, you shouldn't dump U.S. stocks en masse; the future just isn't that certain.
If you want to earn higher returns, you will have to venture abroad. Exchange-traded funds like SPDR MSCI ACWI ex-US (annual expenses: 0.34%, or $34 per $10,000 invested), iShares Core MSCI Total International Stock (annual expenses, 0.16%), Vanguard FTSE All-World ex-US (0.15%) and Schwab International Equity (0.08%) all offer exposure to hundreds of overseas stocks at extremely low cost.
"Foreign stocks are so much cheaper, you'll probably get some degree of outperformance [from them] even if economies outside the U.S. don't do as well," says Mr. Ramsey of Leuthold Weeden. "You really don't need to be right on the fundamentals when the valuation gap is this wide."
— Write to Jason Zweig at firstname.lastname@example.org, and follow him on Twitter:@jasonzweigwsj