Here’s why emerging markets are in an uptrend

Bargain hunters may want to look abroad for deals…

With U.S. markets at all-time highs, emerging markets are starting to look appealing.

[Emerging markets are countries with some form of market exchange and regulatory body. They’re not as advanced as developed countries like the United States or Germany… but their economies are more advanced than developing nations.]

The iShares MSCI Emerging Markets ETF (EEM) tracks this sector.

From its 2010 peak to its 2016 valley, EEM dropped 40%. It recovered about 20% last year (see chart below).

But—as I’ll show you in a moment—there’s still plenty of upside. We could be looking at the start of a 10-year rally.

So, what drove down emerging-market stocks to historic lows by 2016?

Fear.

Corruption in Brazil… inflation in Argentina… a debt bubble in China… and political turmoil in Russia have scared investors out of these markets.

Investors also avoided these markets because of a strong U.S. dollar.

There are several reasons for this… and most of them make a lot of sense.

One of the biggest reasons behind the tank: Many emerging-market companies have U.S.-dollar-denominated debt.

A stronger dollar makes those debt payments more expensive. But those fears are now priced into the market.

Over the past year, the U.S. Dollar Index rose 4%. Meanwhile, emerging markets are up 20% (as you can see in the chart above).

These markets seem to have found a bottom and are now in an uptrend. In fact, they could see strong growth over the next 10 years.

Emerging Markets Are on the Rebound

One way to compare the value of different markets is to use the cyclically adjusted price-to-earnings ratio—or CAPE ratio.

The CAPE ratio averages the PE ratio of a market over 10 years.

Some investors prefer the CAPE ratio because it smooths out short-term fluctuations found in the standard P/E ratio… which generally tracks earnings over a 12-month period.

Per investment firm Research Affiliates, emerging markets had a CAPE ratio of 9.6 at the end January 2016. Today, the ratio sits at 11.

By comparison, U.S. markets have a CAPE ratio of 28. That’s the third-highest ratio in U.S. history.

The two times it was higher? Right before the Great Depression in 1929… and right before the tech bubble burst in 2000.

Now, here’s why those ratios are important…

Research Affiliates found only 24 occurrences of any country’s CAPE dropping below 10 over the past 20–30 years.

On average, those countries’ stock markets rose a dramatic 125% in the following five years.

Those findings are similar to a study done by quantitative analyst Meb Faber.

In his book Global Value, Faber found that when a country’s CAPE ratio fell below 10… it had real returns over 12% per year for the following 10 years.

[A real return is a rate that has been adjusted to remove inflation.]

Meanwhile, expect a slowdown in U.S. markets.

As the CAPE ratio rises, future returns are generally lower.

Faber’s study suggests future real returns of the U.S. market will be about 3%. That’s 9% lower than the expected 12% return on emerging markets.

Key takeaway: Emerging markets look to have bottomed and appear to be in a potential long-term uptrend. It’s a good time to scoop some up on the cheap. Meanwhile, U.S. stocks look expensive. Be careful when choosing them.

Regards,

Nick Rokke, CFA
Analyst, The Palm Beach Daily

One reason U.S. stocks are so expensive is because investors are wildly optimistic.

That’s based on recent numbers from the U.S. Consumer Confidence Index. It just hit a 15-year high. The previous high was in 2007 (see chart below).

The index usually peaks right before a downturn. The previous record in 2007 happened just a year before the financial collapse.

Just another reason to be selective with your U.S. investments.

—Nick Rokke

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