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.