After a dismal decade of slowing GDP growth and stagnant earnings, emerging stock markets are showing signs of life. Overall returns are dampened by the value destruction of private company stocks which has been engineered by China’s government over the past year, but returns for EM ex-China have been much better. Most importantly, some of the cheaper markets in EM have started to take off, which is catching the attention of trend followers and bringing new capital into play. This is happening partially because of a more favorable environment for value stocks, cyclicals and commodities, but also because a rotation out of long-duration tech “dreamer” stocks has been triggered by rising interest rates. All of this is good, but, unfortunately, EM is not yet out of the woods because storm clouds are staying put; these are, specifically ,the rising USD, the tightening of U.S. monetary policy and the explosion of food and energy prices. This is a lethal combination for emerging markets.
Looking beyond the turbulence of the short term, the market action should be a major comfort to long run investors. For the first time in a while, the cheap markets are performing much better than the expensive markets, and investors are taking notice.
We turn to our CAPE methodology as a contribution to taking long term allocation decisions in emerging markets. CAPE provides insight on where valuations stand relative to historical trends and can help to structure mean reversion trades which have a good chance of working over a 3-5 year time horizon. We combine CAPE with macro-economic conditions and market technicals to determine entry and exit points in the context of a long term allocation strategy. 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 tool for 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, all the markets with the lowest valuations and highest expected returns are currently facing difficult economic and/or political prospects 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, that Chile’s constitutional reform will not structurally impair growth prospects and that China’s absurd vendetta against its most innovative and dynamic private firms will come to an end. Until recently, none of these trades has worked. Still today, Chinese stocks are sliding, but the other cheap markets — Turkey, Brazil, Chile and South Africa — are all doing much better, which is heartening.
Why are the expected 7 year future returns almost always higher than the 7 year annual return? Even in cases when the CAPE is higher than the historic average.