Stocks and Shares

These stock markets are up 23% in three months

Emerging market stocks are up 23% in the past four months. After a grinding five year bear market, does this signal a new bull? Certainly they remain attractively priced, overall. But there’s a clear short-term risk still hanging over them.

This year opened with a tough start for all stock markets. In the first three weeks of January the MSCI Emerging Markets index fell 13%, measured in US dollars. The US market fell 9%. The MSCI World ex USA index – which is made up of developed country stocks outside the US – fell 12%.

But since 20th January there has been a massive rebound. It turns out the world wasn’t about to end. Emerging markets are now up 7.5% year-to-date, the USA is up 3.2% and other developed markets are up 2.3%.

Perhaps more significantly, the MSCI Emerging Markets index has risen a massive 23% since the January bottom. Any move over 20% is what most people consider to be a “bull market”, especially when it happens in just three months.

Of course, it may not last. But for now things look distinctly interesting in the world of emerging market stocks. This big move signals renewed buyer interest.

Some individual country markets have raced ahead at an incredible pace – even taking account of the early falls in January. Here’s a chart of the biggest winners this year, using MSCI country indices and all measured in US dollars. I’ve also added a bar for emerging markets as a whole, and thrown in the USA and non-US developed markets for comparison.


You can see that almost all of the big winners are emerging markets. Not just that, but a common theme is that the biggest winners are mostly commodity producing countries. In fact Canada is the only developed country shown, since it’s a big commodity producer. Commodity prices have been recovering.

Of course not all of the emerging markets are good places to invest right now. Earlier in the week I highlighted the huge ongoing political risks in Brazil, and my relative preference for Colombia. And although Argentina has a more sensible government these days, its stock market is far from bargain levels, and there’s a lot of mess to sort out. Some countries look quite expensive, such as Chile, Indonesia or India. Others are cheap, such as Russia, China or South Korea.

…emerging market stocks are much more reasonably priced than developed markets. This is especially true when compared to the expensive US market.

But taken as a whole, the big difference with developed markets – apart from the recent outperformance – is that emerging market stocks are much more reasonably priced than developed markets. This is especially true when compared to the expensive US market.

Currently the S&P 500 index of US stocks has a P/E ratio of 24.2 and price-to-book (P/B) ratio of 2.8. P/B compares the total value at market prices, or market capitalisation, with the net book value of the companies.

[Note: net book value is all the assets less all the liabilities – ie everything a company owns less everything it owes – and is also known as shareholders’ equity.]

By comparison the MSCI Emerging Markets index has a P/E of 13.7 and P/B of 1.4. So the P/E is 43% lower than the S&P 500 and the P/B is 50% lower. That’s a huge difference.

The bottom line is that emerging market stocks are dramatically cheaper than US stocks. But perhaps there are good reasons for that? For example, are US companies significantly more profitable than the ones based in emerging markets? Is there some reason to pay a massive premium in the US?

The clear answer is no. US companies are currently marginally more profitable that emerging market ones, but nowhere near enough to justify such a big valuation discrepancy.

One way to look at this is to calculate how much profit companies are squeezing out of their net assets. This is known as the return on equity, and is expressed as a percentage. This is an important figure, as it tells us how efficiently the shareholders’ capital is being used to generate profits.

The return on equity for companies in the MSCI Emerging Markets index is 10.2%. The same figure for the S&P 500 is 11.7%.

[Note: you can easily work this out for yourself if you have two other figures: the P/E and P/B ratios. Return on equity is net earnings (E) divided by book value (B), expressed as a percentage. P/B divided by P/E is the same thing: E/B.]

In other words, using this measure US companies are 15% more profitable than emerging market ones. Yet they trade 77% more expensively on a P/E view, and 100% more expensively on a P/B view.

Clearly, emerging market stocks are priced much more reasonably than US ones, given the similar return on equity. So investors in the emerging market index are likely to make a lot more profit over time than owners of US stocks.

Of course getting to where we are today has been another story. Emerging markets have been in a five year bear market, since April 2011. Some of them started out being too expensive. Some have been slammed by collapsing commodity prices.

The latter has obviously hit profits of commodity producing companies, but also caused currencies to fall in commodity dependent countries. This has meant profits, when translated into US dollars, have fallen. Of course that could reverse if commodities keep rising, or even if they just stop falling.

A lot of investors pulled out of emerging market stocks in recent years. The end result is that a lot of countries are trading on the cheap side these days.

A lot of investors pulled out of emerging market stocks in recent years. The end result is that a lot of countries are trading on the cheap side these days.

On the other hand, US stocks have just kept on rising to higher and higher valuations. Paper profits rolled in, as valuation multiples climbed.

The resulting over-valuation has left investors in US stocks sitting on a potential time bomb. US corporate profits are already falling.

The historical record doesn’t provide any comfort either. Since 1871 there has been a major market downturn or crash every six years, on average.

The last big fall started in October 2007, or eight and half years ago. By March 2009 the market had been cut in half.

In other words, the expensive US stock market is living on borrowed time, despite Janet Yellen’s best efforts to keep it propped up for a little longer.

Just to get back to a level consistent with the historical average valuation the S&P 500 would have to fall by about 40%, to around 1,260. But that kind of steady fall or sudden crash may not happen. Instead, US stocks could just muddle along for many years in a sideways market.

If the P/E holds up then investors would make low single digit annual profits. If it steadily drifts back down to the average they would make low single digit annual losses as stock prices fall. Nothing dramatic, but not worth the risk either way.

Some of the cheaper markets could even deliver average annual returns in the high teens or low 20s.

It seems clear that investors should be focusing their attention on emerging market stocks. Overall they’re priced for high single digit to mid-teen percentage returns over the next five to ten years. Some of the cheaper markets could even deliver average annual returns in the high teens or low 20s.

There are still risks out there – and one stands out above all others. If, or when, the US stock market crashes I’d expect emerging market stocks to get dragged down even further. They’d be sucked into the downdraft of a market panic, along with everything else.

But because they are already attractively priced, I’d also expect them to recover relatively quickly – within a year or two. And if there is no crash then investors that don’t buy today run the risk of missing the boat altogether.

Emerging market stocks bought now will be excellent investments in the medium to long term.

And if prices fall further in the short term? Well, that’s easy.

Just buy some more, when they’re even cheaper.

Stay tuned OfWealthers,

Rob Marstrand

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.