Ranking of Regional Markets and World Sectors Applying the Residual Income Model and the Market Implied Expected Returns/Cost of Equity (July 2024)
Ranked by Intrinsic Valuation
Applying the residual income model and utilizing the market-implied expected return (Ke or the cost of equity) derived from the Lumen Compass, we can estimate the intrinsic value (next 10-year expected return) of each market, region, and world sectors.
We then rank the intrinsic value showing the US S&P 500, the Japan Topix and the US small caps are the cheapest while China, EAFE, and Europe are the most expensive.
Next to intrinsic value, we calculate the “Intrinsic Risk”, which is calculated by the maximum downside (%) as a proportion of the spread (range) between the maximum upside (%) and the maximum downside (%).
In the most practical and coherent definition, financial risk is the possibility of losing capital permanently and has nothing to do with the preposterous practice out there to confuse risk with volatility and precisely measure it with the standard deviation of an allegedly normal distribution of returns (Bell Curve).
Thus, it stands to (our) logic that risk is essentially a lack of value, i.e., if an investment has zero fundamental value, it stands to reason that it has one hundred percent risk and vice versa.
Accordingly, “intrinsic” risk is inversely correlated with intrinsic value. At Lumen, we measure intrinsic risk by stress-testing a Residual Income Model across its major inputs and using our proprietary estimate of market-implied expected return as the discount rate.