One common misperception about global markets is that there is something fundamentally “wrong” with one market trading at several times the price/earnings multiple of another. But there is nothing in equilibrium theory to suggest that P/E differences between markets represent investment opportunities.

The appropriate strategy for exploring global asset allocation is not to compare the valuation in one country directly with the valuation in another. Rather, one should compare the earnings yield in one country with the cash or bond yield in the same country, thereby arriving at a measure of the equity risk premium in that country. Deviations from the “normal” equity risk premiums can then be compared across country boundaries.

As economic and political risks differ across countries, so should equity risk premiums. Changes in the relative risk premium between two equity markets can, however, provide a measure of changes in relative valuation and, potentially, of changes in the relative attractiveness of the two markets. This suggests a framework for global asset allocation that allows for comparisons both within and between countries. In essence, such a framework would enable one to compare Japanese stocks with German bonds or with U.S. cash.