According to David Rosenberg of money manager Gluskin Sheff the U.S. stocks market is overvalued by 35% based on Shiller P/E ratios.

The S&P 500 is up 9% YTD and most stocks have recovered strongly since the March lows of last year.The current P/E of S&P 500 is 21. However is this the time to invest in U.S. stocks?

According to an article in MoneyWeek, the current P/E of U.S. stocks is about 22. Historically when the P/E ratio exceeds 20, stock investments have lost money over the next five years. Investor Jeremy Grantham predicts a yearly return of just 0.40% for the next seven years. When inflation is taken into account investors will loose money if they invested in the markets now.

The above chart shows that stocks traded above 20 times earnings before the big crashes of 1929, the late 1960s and 2000.

Another chart from Societe Generale below shows that the cyclically-adjusted P/E of S&P 500 is over 20 now. This ratio is adjusted for economic cycles by taking an average of earnings over the past ten years.

Source: US equity bulls are pricing in Nirvana, MoneyWeek

The above charts confirm that U.S. stocks are not undervalued based on the factors noted. Further rise in equity prices have to accompanied by rise in earnings.

P/E ratios have been expanding in other markets as well though earnings have not grown significantly. For example, among the emerging markets, the P/E of BSE 500 stocks in India has shot up from 11.7 times (12-month trailing earnings) in March 2009 to over 20 last month. In 2009, when the total net profits of the BSE 500 companies grew by 30%, their market capitalization increased by 130% showing the irrational exuberance of investors.

Global diversification is an integral strategy of a well-built portfolio.It is even more important to make sure that diversification is done right.

Australia is classified as a developed economy and its main stock market index the Australian All Ordinaries Index is part of the MSCI World Index. In contrast South Africa is considered as an emerging market and its main index the All Share Index is included in the MSCI Emerging Market Index.

However the developed market of Australia is highly correlated with emerging market of South Africa. This is because the economy of both these countries are natural-resources based. So investing in these two markets at the same time would not offer the diversification desired by an investor.The following charts proves this point.

Returns of Australia’s  All Ordinaries Index Vs. South Africa’s All Share Index:

The graph shows that both the markets track each other almost consistently. Australia has been more volatile but offered better returns especially during the commodity boom from 2003 and 2007.

Correlation between South Africa and Australia:

Source: http://www.equinox.co.za

The table above shows that the Australian All Ordinaries and the South African All Share Index are quite highly correlated to one another.The Australian index has a higher correlation to the MSCI World index than the All Share Index. However both the indices have the same correlation to the MSCI Emerging Market index, which is interesting.

ETFs Performance:

The chart below shows the 5-year performance of the iShares MSCI Australia Index fund (EWA) and the iShares MSCI South Africa Index fund (EZA).

Based on the above analysis it is clear that when choosing different markets for diversification purposes one must choose the right countries.