Shaking Off the Fears of Emerging Market Investing

Throughout our working years, most of us try to ensure that we receive adequate compensation for our labors. We try to receive an “honest day’s pay for an honest day’s work.” And if there is to be any dishonesty in this calculation, we prefer that we be dishonestly overpaid.

But when it comes to investing, most of us are much less exacting. We simply expect to do okay “over the long run.” And because we expect to do okay over the long run, we are very tolerant of disappointing returns over the short run. In other words, we expect to get underpaid from time to time.

Such complacent – almost fatalistic – attitudes usually produce subpar results. But not always. During most of the last 30 years, simply buying and holding US stocks would have produced a satisfying result. There was enough stock market gold on Wall Street to line the pockets of almost every prospector. But those days are gone.

During the last ten years, the S&P 500 Index has produced a negative total return. Over the identical timeframe, most indices of Emerging Market stocks doubled or tripled. Clearly, the buyers of US stocks did not receive “an honest day’s pay.”

These investment results from the last ten years are not necessarily prologue to the next ten years. But what if they are? What if the glory days of “buy and hold” are gone for good?

A couple days ago, your editor examined this troubling thought before a small group of investors here in Rancho Santana, Nicaragua. In a brief presentation entitled, “Measure for Measure – Defining Risk in a Post-Bubble World,” your editor suggested that the time has come to carefully evaluate the measure of risk one is taking for each measure of return. Now is the moment, he asserted, to insist on an honest day’s pay, or to saddle up and ride out to a place that treats capital more hospitably.

To underscore this imperative, your editor pointed out that lots of investors carry massively “overweight” positions in US stocks without ever examining and assessing the risks they are taking relative to competing investment opportunities, like Emerging Market stocks. That’s a potentially grave mistake, especially when one considers that the investment world is becoming increasingly bi-polar, to the benefit of the Emerging Markets.

In the post-bubble world:

1) The West is characterized by:

a) Rising indebtedness at every level of society,
b) Towering “legacy” pension and welfare obligations and;
c) Debilitating and hostile regulatory regimes.

2) “The Rest” is characterized by the opposite.

As the global financial markets increasingly reflect these dual trends, the distinction between “Developing” and “Developed” is blurring to the point of utter irrelevance. Notably, the stock markets of the Developing World are becoming less volatile…at least relative to those of the Developed Markets.

Emerging Markets vs. S&P 500

Furthermore, Developing World stock markets are delivering much higher returns per unit of volatility. In fact, foreign stocks in general are delivering high relative returns and low relative volatility. During the last ten years, for example, while the S&P 500 was busy delivering a loss, the SoGen International mutual fund was delivering an average annualized return of nearly 12%. Additionally, the SoGen fund produced its returns with 30% less volatility than an S&P 500 Index Fund!

Based on numbers like these, there’s no good reason to blindly buy an S&P 500 Index Fund. But of course, we all know that solid facts sometimes produce flimsy deceptions. So the point of this discussion is not to condemn US stocks for all time, but merely to ask the questions, “Why are you buying what you are buying? Are you getting paid adequately for the risks you are assuming?”

These questions are easier to answer clinically than they are to resolve emotionally. Even if, for example, a dispassionate analysis of the data would lead us to allocate the majority of our portfolio to Brazilian, Indian and Norwegian stocks, many of us would have a hard time pulling the trigger. US stocks simply feel safer. 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.”

Eric Fry
for The Daily Reckoning

The Daily Reckoning