Emerging markets underperformed the S&P 500 in 2024, extending a long losing streak. This marks the seventh consecutive year of underperformance and the thirteenth in the last fifteen years. Only Taiwan and Argentina (actually in the Frontier Market Index) managed to outperform the S&P 500 .
The U.S. market appears to be experiencing a blow-off rally, fueled by a broad consensus on an immaculate soft landing for the U.S. economy and optimism about AI-driven productivity growth. The U.S. market is also benefiting from a remarkable expansion in profit margins, driven almost exclusively by the “Magnificent Seven” technology giants, which is reflected in high expectations for earnings growth in 2025.
The strength of the S&P 500 can be attributed to two factors: first, a remarkable decade-long expansion in profit margins, of which about 60% was caused by lower interest rates and globalization, two trends that are now clearly in reverse; and second, an expansion of earnings multiples, which has brought valuations to extremely high levels on most measures.
The valuation premium of the S&P 500 over the MSCI EM Index closed the year at high levels, surpassed only by the 2016–2018 and 1998–1999 periods. The rising valuation premium over the past three decades may reflect the U.S. market’s transition from one dominated by capital-intensive cyclical businesses to one dominated by capital-light companies with persistent and rising monopolistic profits. Unfortunately, this transition has not taken place in emerging markets, except for a while in China until Chairman Xi squashed the tech sector to “safeguard social harmony.”
Earnings growth has been the main driver of the S&P 500’s outperformance relative to emerging markets over the past ten years, as shown below. From the inception of the MSCI EM Index in 1986 until 2014, earnings growth was similar in both markets, but a dramatic split occurred from that point on. While emerging markets have been in a prolonged earnings slump, S&P 500 earnings have surged since 2014, largely due to the spectacular margin expansion of the tech giants. Although the strong dollar has contributed, it accounts for only about 20% of the relative outperformance. Thus, the key question for investors is: How much longer can the “Mag 7” phenomenon continue?
The chart below estimates the current expected returns for emerging markets and the S&P 500, based on a CAPE ratio analysis. The Cyclically Adjusted Price-Earnings (CAPE) ratio, which calculates the average of inflation-adjusted earnings over the past ten years, helps smooth out earnings cyclicality. This tool is especially useful for highly cyclical assets like emerging market stocks and has a long history of use among investors, gaining popularity more recently through the work of Professor Robert Shiller at Yale University. We use dollarized data to account for currency trends, and the seven-year expected returns are calculated assuming each country’s CAPE ratio will revert to its historical average over time. Earnings are adjusted according to each country’s position in the business cycle and are assumed to grow in line with nominal GDP projections from the IMF’s World Economic Outlook (October 2024).
As logic dictates, countries with “cheap” CAPE ratios below their historical average tend to have higher expected returns than those with CAPE ratios above their historical average. These expected returns are based on two key assumptions: first, that the current CAPE levels relative to historical averages are unjustified; and second, that over time market forces will correct the discrepancy. Historical data strongly supports the second assumption over seven- to ten-year periods, though not in the short term (one to three years). The model may give a false signal if a country’s historical CAPE average is out of sync with its current growth prospects. For example, one could argue that Chile’s current growth prospects do not justify its historically high CAPE ratios. The same may be true for the Philippines.
The following chart shows country returns for 2024 in relation to which markets had the highest 7-year expected returns at year-end 2023. Of the markets with high long-term expected returns, only Peru and Turkey currently have good momentum characteristics. The chart shows that the CAPE ratio was not predictive of performance returns over this period, as is frequently the case. Over one to three-year time frames, momentum, narrative, liquidity, and cyclical conditions have a much greater impact on performance than long-term valuation parameters. Nonetheless, 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.
Looking ahead, Peru and Turkey may be well-positioned to perform over the next year, as they offer both cheap valuations and momentum and are in the early to middle phases of their business cycles. However, rising geopolitical tensions and sluggish global growth create an unfavorable investment environment. As always, a strengthening dollar indicates the need to remain focused on dollar-denominated quality assets.