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Emerging Markets are Cheap

23% in a Week

Written by Christian DeHaemer
Posted August 13, 2013

Don't look now, but the Great Inverse Decoupling just happened...

It must have been about six or seven years ago now when there was a great and raging debate in the markets about whether emerging markets (EM) stocks would decouple from the S&P 500.

These were the days when China was posting 10%-plus GDP numbers on a regular basis while the United States fretted over wars and housing costs.

Back then, China and the rest of the emerging markets did decouple from the S&P 500. They went up at a much faster rate.

If you had invested in the S&P 500 ten years ago, you would be up 68% right now.

If you had bought the Vanguard Emerging Markets Stock Index Fund (NYSE: VEIEX), you'd be up 150% right now. You'd have done even better if you had sold in 2007... VEIEX ran from 10 in 2000 to 36 in 2007, and is now at 25.

So in the last six years, you'd have lost one-third of your investment in emerging markets.

In other words, ten years ago, you should have invested in emerging markets as the commodity supercycle, spurned on by outsized Chinese growth, boosted the fortunes of countries that supplied raw materials and cheap manufacturing.

And after the market crash of 2008, you'd have been best served playing along with the U.S. Federal Reserve as it pumped up Wall Street.

Dangerous Predictions

What then, dear reader, will happen over the next five years?

Will China bounce back? Will the Fed run out of greater fools? Will gold go to $5,000 an ounce and a Big Mac cost a C-note?

I don't know, and neither does anyone else.

We can only speculate, and to do that, we use logic, forethought, and historical trends. I have little enough of the first two, but the third we can find in spades.

So let's start with the basics.

Despite what you might hear from your wife, the point of investing is to make money. To make money, you buy low and sell high.

Now, this is where it gets tricky...

Just what is low, and what is high?

One of the simplest ways to value high and low is to look at the price-to-earnings ratio (P/E).

Right now, the P/E ratio on the S&P 500 is 19.24.

If we remember that buying a stock is the same thing as buying a part of a company, it means that given today's earnings, it will take the better part of two decades to get your money back.

That's a quarter of your life!

That seems like a lot when you put it in those terms, but historically, it's not that bad.

Going back over 100 years, the mean P/E ratio is 15.50, and the median is 14.51. The low was 5.31 in 1917, and the high was 123.79 in 2009.

S&P 500 P/E Chart

sp500 aug 12

What is interesting is that 1917 and 2009 were both buys...

In 1917, the S&P 500 was a buy because earnings took off. The P/E was low because the price didn't catch up with the earnings.

In 2009, the exact opposite happened: The “P” fell sharply, but the “E” evaporated. EPS for the S&P 500 fell from a high of $95 in 2007 to around $15 in 2009.

Today the number EPS is $87. (This figure is inflation adjusted, as reported in March by Standard and Poor's.)

Granted, the P/E ratio is an imperfect indicator — but there are things it gets right. A low P/E in a negative environment is a time to buy. Just look at 1980, when the S&P was trading at 100.

It is now trading at 1,687. That means your $100,000 would have turned into $1.68 million — not bad, even if you account for inflation ($553,198).

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Emerging Market P/E Ratios

Back to our original point: The emerging markets and the U.S. markets have decoupled yet again.

This time, the U.S. markets are doing well, while the emerging markets are falling.

As we have noted, the P/E on the S&P 500 is above 19, while the P/E on emerging markets is now at 10 and change. And you can see in the chart below that EMs are now about 30% to 35% undervalued.

chart1_wd_08132
Furthermore, EM companies have a higher return on equity than more mature, U.S.-based companies.

Emerging markets are expected to grow GDP at 4.5% over the next 12 months; the U.S. expected GDP is 2.2%.

If you are a value investor or like to buy low, emerging markets have priced in failure, so any bit of good news will send them higher.

I've been getting readers of Crisis and Opportunity into places that are much abused and long forgotten, like Greece.

Our first pick is up 23% in a week on news that the country hit its budget targets.

Imagine how high it could go if the youth unemployment rate drops from the stratospheric 65%...

The upshot is that it's time to start looking at beaten-down, emerging market winners again.

All the best,

Christian DeHaemer Signature

Christian DeHaemer

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Since 1995, Christian DeHaemer has specialized in frontier market opportunities. He has traveled extensively and invested in places as varied as Cuba, Mongolia, and Kenya. Chris believes the best way to make money is to get there first with the most. Christian is the founder of Bull and Bust Report and an editor at Energy and Capital. For more on Christian, see his editor's page.

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