Emerging market stocks underperformed the S&P 500 during the first half of 2024, extending a long losing streak. This is the seventh year in a row of EM underperformance, and the tenth out of the last eleven years. This leaves the valuation premium of the S&P 500 at its highest level since the peak of the tech bubble in 2000. The U.S. market appears to be enjoying a blow-off, driven by a consensual view on an immaculate soft landing for the U.S. economy and optimism about future AI-fueled productivity growth. The U.S. market is also enjoying a remarkable resurgence in profit margins driven almost exclusively by the Magnificent Seven technology titans.
The strength of the S&P 500 can be attributed to both multiple expansion and earnings growth. The valuation premium of the S&P 500, as shown below, is at very high levels, but still lower than in 2000 or 2015, which were the last two opportunities to make extraordinary relative returns in EM.
However, earnings growth has been by far the main contributor to S&P 500 outperformance over the past ten years, as shown below. While EM has been in a prolonged earnings funk, S&P 500 earnings have surged since 2014, mainly because of the spectacular margin expansion of the tech titans. Though the strong dollar has helped, it accounts for only some 20% of the relative outperformance. Therefore, the question all investors should ask themselves is how much longer the “Mag 7” phenomenon can continue?
The chart below estimates the current expected returns for EM markets and the S&P 500, based on a CAPE ratio analysis. The Cyclically Adjusted Price-Earnings Ratio (CAPE) is calculated using the average of inflation-adjusted earnings for the past ten years, which helps to smooth out earnings’ cyclicality. This tool is particularly useful for highly cyclical assets like EM stocks and has a long history of use among investors, gaining popularity through Professor Robert Shiller at Yale University. We employ dollarized data to capture currency trends. The seven-year expected returns are calculated assuming that each country’s CAPE ratio will revert to its historical average over the period. Earnings are adjusted according to each country’s current position in the business cycle and are assumed to grow in line with nominal GDP projections from the IMF’s World Economic Outlook (IMF WEO, April 2024).
As expected, countries with “cheap” CAPE ratios below their historical average tend to have higher expected returns than those considered “expensive” with CAPE ratios above their historical average. These expected returns are based on two significant assumptions: first, that the current level of CAPE relative to the historical level is not justified; second, that market forces will correct the current discrepancy. Historical data strongly supports the second assumption when considering seven-to-ten-year periods but not in the short term (one to three years).
Nevertheless, during certain periods when “cheap” markets on a CAPE basis exhibit short-term outperformance (one year or less), investors should take note, as the combination of value and momentum is compelling. As depicted in the chart below, the current environment is not particularly supportive of using CAPE as an investment timing tool. Over the past twelve months, holding the “cheapest markets” (on the left side of the chart) has had mixed results, working for Colombia and Turkey but not for Brazil, Chile, or the Philippines. On the other hand, expensive markets (right side of the chart) like the U.S., India, and Argentina have produced stellar results. It can be concluded that for the time being, liquidity and not value is driving performance.
Looking forward, Turkey, Colombia, and Peru look well-positioned to perform, having both cheapness and momentum and being in the early to middle phase of their business cycles. The Philippines looks compelling from a valuation and business cycle aspect but lacks price momentum.
Rising geopolitical tension and slow growth do not create a conducive investment environment. As always, a strengthening dollar signals the need to stay invested in dollar-denominated quality assets.