Buy the Emerging Markets, Part II

What’s wrong with this picture?

US vs. Brazil Annual Government Budgets

This chart shows the comparative fiscal trends of the US and Brazil during the last decade. Back in 1999, the US was running a budget surplus and Brazil was running a deficit equal to about 9% of its GDP. Over the ensuing 11 years, those conditions flip-flopped. Brazil is now running a very slight deficit and the US is running a very large one.

Brazil is representative of many Emerging Markets. If we broaden out our analysis, what we find is not just a relative improvement in government finances, but also a dramatic improvement in the private sector. Half of global GDP is now produced by what we call the Emerging Markets. Looking farther out, the IMF expects the Emerging Markets to produce more than 60% of the world’s GDP growth over the next four years – or about five times the growth the G-7 countries will contribute. The IMF is not omniscient. It has been known to make a mistake from time to time. But its forecast is probably close to the target in this case.

BRIC GDP Growth vs. G-7 GDP Growth

And yet, despite data like these, many investors – both professional and individual – carry massively “overweight” positions in US stocks. They just can’t seem to break that bad habit.

Why? Because US stocks are familiar! They are IBM and GE and McDonald’s.

The argument in favor of Emerging Markets is easy to embrace clinically, but not easy to implement emotionally. US stocks simply feel safer than Emerging Market stocks. In response to such anxieties, William Shakespeare’s Measure for Measure provides an insightful counterpoint: “Our doubts are traitors, and make us lose the good we oft might win, by fearing to attempt.”

The time has come to cast aside our fears and to embrace the world as it actually is, not as we might like it to be. In the world as it actually is, for example, Emerging Market stocks are performing much better than Developed World stocks – both in absolute terms and in so-called “risk-adjusted” terms. Emerging Market stocks aren’t just producing higher returns, they are producing these returns with very modest amounts of volatility.

Over the last decade, for example, the MSCI Emerging Markets Index has tripled, while the S&P 500 Index has produced a loss…including dividends. More recently, if we compare these indices from the bear market lows of March 2009 to the present, we see that Emerging Market stocks are up more than 120%, compared to a gain of only 60% for the S&P 500. But despite producing double the return of the S&P during the last 18 months, the MSCI Emerging Markets Index was only slightly more volatile than the S&P 500.

More intriguing is the comparison between Emerging Market stocks and the traditionally risky sectors of the US stock market – things like homebuilders and bank stocks. It used to be that these risky assets would all trade very closely with one another. Emerging Markets were considered risky, just like homebuilders and bank stocks. So they all went up and down together…especially down.

That’s not happening anymore. The risky stuff in the US is still plenty risky…and doing poorly. But the “risky” Emerging Markets are doing very well. This divergence has become particularly acute over the last four months. Since the first week of May, the MSCI Emerging Markets Index has advanced 10%. But over the same timeframe, the ISE Homebuilders Index is down 15% and the KBW Bank Index is down 20%.

Net-net, it has become more important now than perhaps at any other time during the last 30 years to ask, “What am I getting for the risk I am taking?”

For the last 10 years, the US stock market has delivered lots and lots of bumps, lots and lots of volatility, and absolutely zero return. That’s not good. There is no way of knowing, of course, whether this recent past will also be prologue. But there is a way to guess…intelligently. Simply stated, the economies of many, many Emerging Markets are performing much better than their counterparts in the Developed World. And this trend seems very likely to continue for many years.

And yet, Emerging Market valuations remain below those of the Developed World. At the current quote, the MSCI Emerging Market Index sells for about 13 times earnings, while the MSCI EAFE Index (non-US Developed World stocks) sells for 16 times earnings. For additional perspective, the NASDAQ Composite Index currently trades for a hefty 25 times earnings. Thirteen times earnings is not what one could call “dirt cheap,” but it is certainly “cheaper than” the EAFE Index or the NASDAQ Composite.

There are many ways to capitalize on the future relative strength of the Emerging Market economies: Foreign stocks and/or real estate are a couple obvious examples. That said, please invest very selectively. Do not invest in Emerging Markets – or in any market – because you feel like you have to, or because you have some vague idea that you ought to. Invest in the Emerging Markets only when – and if – you recognize a very specific opportunity that is worth taking a very specific risk.

Thank you.

Eric J. Fry
for The Daily Reckoning