January 2022 – The Emerging Markets Investor

Does CAPE Work For Emerging Markets?

The CAPE methodology is well suited for volatile and cyclical markets such as those we find in Emerging Markets. Countries in the EM asset class are prone to boom-to-bust economic cycles which are usually accompanied by large liquidity inflows and outflows that have significant impact on asset prices. These cycles often lead to periods of extreme valuations both on the expensive and cheap side and the CAPE has proven effective in highlighting them.

The CAPE (Cyclically adjusted price earnings) takes the average of inflation-adjusted earnings for the past ten years, which serves to smooth out the cyclicality of earnings. We use dollarized data so that currency trends are fully captured. This methodology has been used by investors for ages and has been popularized recently by professor Robert Shiller of Yale University.

The charts below illustrate the relationship between stock market total nominal returns and the level of the CAPE ratio for Global Emerging Markets, the S&P500 and 18 emerging markets. The data covers the period since 1987 when the MSCI EM index was launched. The charts show a clear linear relationship between CAPE and returns with particular significance at extreme valuations. Country data is more significant because the CAPE ratios capture better the evolution of the single asset.

CAPE works particularly well in markets with highly cyclical economies subject to volatile trade and currency flows (Latin America, Turkey, Indonesia); less well for more stable economies (eg, East Asia).

S&P 500 : The market has not provided 10 year annualized returns above ten percent when CAPE is above 25. Every time that the market has provided lower than 5% annualized return the CAPE has been above 30. The CAPE at year-end 2021 was 39.3, the second highest in history.

2. All date points, including GEM and 18 countries: This is a very noisy graph but the trend is clear. All 10 year periods with returns at least 15% annually started with CAPE below 25.

3. Global Emerging Markets: Clear trend. GEM has never returned less than 10% annually with cape below 10; returns have never been above 5% with CAPE above 20. GEM CAPE ended 2021 at 14.4.

4. China: All high return years started at CAPE below 10; all low returns started at CAPE above 20. China end 2021 at 13.3.

5. India: India performs best with CAPE below 20 and really struggles above 25. 2021 ended at 31.1 which should weigh heavily on future returns.

6. Korea: Clear trendline but slightly more dispersion than in most other markets. Current CAPE is 9.6.

7. Taiwan; All high return decades have started with CAPE below 15; low returns have started above 20. The current level is 27.1, the highest since the Taiwan bubbles of the 1990s.

8. Brazil: Brazil is a good example of a highly cyclical economy prone to boom-bust cycles and unstable liquidity flows. A CAPE of 15 seems to be the dividing line for returns, with equity booms starting with CAPES in the low teens and the market struggling with CAPES in the high teens. At the current CAPE of 10.9, the market is priced to provide high returns.

9. Turkey: Annual returns have been very high when CAPE has approached the five level, and very poor when CAPE reaches the high teens. The current CAPE of 4.1 is the lowest since the early 1990s. This is the fourth time that CAPEs have been below five and on every occasion very high returns have followed.

10. Mexico. Current CAPE is 18.2

11. Philippines

12. Thailand

13. Russia

14. Malaysia

15. South Africa

16. Indonesia

17. Peru

18. Chile

19. Colombia

20. Argentina

CAPE and Expected Returns in Emerging Markets, 2022-2028

The past decade in emerging markets has been one of slowing GDP growth, low earnings and poor returns. By and large, today valuations have come down enough from the lofty levels of 10 years ago to make the markets attractive, particularly compared to the high valuations of the U.S. market. Emerging markets are under-owned and certain segments of the market are extraordinarily cheap. If “value” segments of the market (industrial cyclicals, banks, commodities) continue to rally like they did in 2021, then prospects may be quite good. However, at the same time, the markets face a Fed monetary tightening process that may broadly challenge asset prices and, if history repeats itself, be particularly troublesome for emerging markets.

We turn to our CAPE methodology periodically to shed some light on relative valuations and derive estimates of “probable” future returns. The CAPE (Cyclically adjusted price earnings) takes the average of inflation-adjusted earnings for the past ten years, which serves to smooth out the cyclicality of earnings. This is a particularly useful too lfor highly cyclical assets like EM stocks. At extreme valuations, the tool has had very good predictive capacity in the past. We use dollarized data so that currency trends are fully captured. This methodology has been used by investors for ages and has been popularized more recently by professor Robert Shiller of Yale University.

The methodology sets a long-term price objective based on the expected CAPE earnings of the target year, which in this case is seven years (2028). The CAPE earnings of the target year are multiplied by the historical median CAPE for each market. The underlying assumption of the model is that over time markets tend to revert back to their historical median valuations.

The table below summarizes the results of our calculations for 17 EM countries, global emerging markets (GEM, MSCI) and the S&P500. The expected returns of markets depend on valuation (CAPE ratio) and earnings growth (largely a function of GDP growth). No consideration is given here to possible multiple expansion or the liquidity factors that may have a major influence on market returns.

Not surprisingly, the markets with the lowest valuations and highest expected returns are currently facing difficult economic and/or political prospects and, consequently, have been abandoned by investors. Investing in these countries requires a leap of faith that “normalization” is possible. For example, it assumes that the current crisis in Turkey will be resolved adequately and that Chile’s constitutional reform will not structurally impair growth prospects.

The CAPE methodology is a poor predictor of short-term results. For example, the cheap markets at year-end 2021 all did poorly over the past year while the expensive markets (USA, India) just got more expensive.

Emerging Markets: 2021 in a few charts

2021 saw more underperformance for international stocks (MSWORLD) and emerging markets stocks (EEM)s relative to the S&P500. The U.S. tech titans have become the darling of global investors, considered as the last remaining “safe haven” asset in a low growth and risky world.

EM ex China (EMXC) didn’t perform too badly in absolute terms, in line with MSCI World ex U.S. EM as a whole was weighed down by the collapse of China’s internet stocks (KWEB), the favorites of international funds.

In 2021 investors learned that China cares about its currency and its bond market but not much about stocks , particularly those of “frivolous” companies engaging in anti-social activities (internet). While EM bonds (EMCB,EMHY) lost value relative to U.S. High Yield, China’s bonds (CBON) rose steadily.

In the Chinese market (MCHI), stocks held mainly by foreigners (KWEB, CQQQ) did poorly but local stocks (CNYA) and, even more so, local tech stocks (CNXT) picked up the slack.

Global EM stocks, despite the rally in commodity prices (GYX, industrial) commodities index), did poorly, which is unusual. Commodity-rich markets like Chile (ECH) and Brazil (EWZ) lagged badly. Commodity prices were driven by climate politics and inflation, no longer by China which is not the driver of global growth it once was.

The collapse in the correlation between commodity prices and EM is seen in the extraordinary divergence between Chilean stocks and copper. Chile is overwhelmed by politics, and copper inflows are serving only to facilitate capital flight. Investors in Chile and elsewhere may be anticipating the likely return of strict capital controls.

EMEA ( Europe, Middle East, Africa) led EM equity returns in 2021, boosted by the oil-sensitive markets of the Persian Gulf.

There’s always a bull market somewhere. In 2021 it was U.S. tech titans and the Middle East. Taiwan, India and Vietnam were also winners.

Latin America stocks (ILF) underperformed Asia EM (EMEA), as they have persistently for the past decade.

10.

Technology stocks outside of China fell back to earth in 2021. Latin American tech stocks, fueled by the happy dreams of global venture capitalists led by Softbank, experienced a general collapse.

11.

China’s share of the MSCI EM index fell sharply, replaced mainly by Taiwan and India.

12.

The fall of China’s internet titans caused significant changes to the MSCI EM’s top holdings. Indian stocks are becoming more prominent, a story likely to extend for the coming decade. Commodity related stocks (Gazprom, Vale, Al Rajhi Bank) are back, also a harbinger of things to come

13.

After a decade dominated by growth and momentum, other factors started to work in 2021. Value and small caps outperformed in global EM and every region. The very few still active value investors in EM finally had a good year while most EM active managers (by now almost all closet growth investors) suffered.

14.

All the traditional academic factors did well in 2021, led by small caps (EEMS) and momentum (PIE).

15.

The Covid-19 pandemic has been disastrous for much of emerging markets, the worse hit being Eastern Europe and Latin America. The fiscal impact (higher debt levels) and social consequences (impaired education for the poor) have severely undermined the growth prospects for Latin America.