The Case for Emerging Market Stocks

Forbes.com, Winter, 2016. This article was written with Jim Cahn, the Chief Investment Officer at Wealth Enhancement Group. It was part of a series of articles developed under an agreement with Forbes to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site forbes.com is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.

Emerging market equities have stumbled out of the 2016 gate, continuing a trend of underperformance in the recovery since the global financial crisis. While it can be tempting to capitulate entirely when it comes to your emerging market holdings right now, those able to stomach the volatility may have an opportunity for excess returns. An old adage applies here: Stocks are the only thing that nobody wants to buy when they are on sale.

Counterintuitive to many investors, lower realized returns of an asset class in the past leads to higher expected returns in the future. Historically, investors often treated expected returns as static, agnostic to valuation changes. Worse, investors extrapolated recent realized gains to higher expected gains, a common feature of bubble formations. Nonetheless, if we accept that emerging market stocks are on sale, and therefore are offering higher expected returns, investors still want to know when the inflection point is—in  other words, at what point those high expected returns will transform themselves into high realized returns.

3 Reasons to be Optimistic

1.  While market timing is a fool’s game, there are three reasons to be optimistic that the inflection point is nearing, perhaps in 2016: investor sentiment, valuation and fundamentals. Investors of emerging markets are reducing allocations significantly or altogether. Extreme behavioral overreactions often act as contra-indicators, signaling a good time to buy. Most recently, Bank of America’s Global Fund Manager Survey shows that portfolio managers are more underweight emerging markets than they’ve ever been since the survey began reporting in 2001.

2. As mentioned at the opening, the selloff in many emerging market equities has led to abnormally large valuation discounts. At the time of writing, the MSCI Emerging Markets Index is trading at 11 times estimated earnings, roughly 35% cheaper than the S&P500 forward multiple. While the emerging markets forward P/E has historically traded at a discount to the S&P500, this is the largest discount since the early/mid 2000s—the same time period that saw emerging market outperformance. In the period from 2003-2007, based on the MSCI Emerging Markets Index, emerging market stocks gained 37.11% compounded annually—significantly outperforming the S&P 500’s return of 12.47% compounded annually.

3. The final piece to watch for an inflection change is the fundamental landscape of emerging markets versus the U.S.  The GDP growth differential between emerging markets and the U.S. has declined since 2009, turning negative in 2014. Essentially, the U.S. had a strong post-global financial crisis recovery, while emerging markets decelerated. Looking into 2016, however, Goldman Sachs is predicting that developing countries will grow 4.9% next year, an increase from 2015. Notably, this would be the first acceleration since 2010. Along the way there will be lots of noise about the decline of emerging markets and the end of China’s boom, but steer through the noise to find the signal—emerging market equities offer high expected returns in the intermediate and long-term.

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