Over the past five years (since June 2009), the US economy has outperformed the superior emerging markets by 70 percent in terms of stock market performance. This performance gap was even more pronounced over the past year and a half, with the US market returning 34 percent and the broad emerging index actually down one percent.
Another mark of the growing disparity between the US and emerging markets are recent CAPE (cyclically adjusted P/E) levels. These are price to earnings ratios that smooth out the effects of more short term cyclical ups and downs in earnings. The latest CAPE for US stocks stands around 25 (well above average) while CAPEs vary widely among emerging countries but most are between 5 and 20 with many in the 10-15 range.
So with this seemingly large valuation advantage in emerging market countries, should traders simply go ‘all In' and invest in something like the Vanguard FTSE Emerging Market ETF (NYSE: VWO)? One could probably do a lot worse, but there may be a better way.
By researching and tracking several metrics on ‘easily investable' individual emerging countries, an investor can greatly increase their chances at making greater returns and reducing risk versus owning a market cap weighted emerging index.
Below are the metrics researched for each country along with a brief explanation of each.
• Demographics: In general, the younger the population of a country, the better for the economy, growth and the stock market. Investors should look at the percentage of the population below 25 years old and above 54 years old. The below age 25 data point gives a good idea of potential labor force growth. The older than 54 data tells us how significant the burden of an older (non-working) population will be on the overall economy.
• Real Interest Rates: The higher the REAL interest rate in a country relative to other countries, the more attractive investment in that country becomes. The Real interest rate is defined as what return investors can receive on cash/short term bonds minus inflation in that country. Currently, most emerging markets have low to mid single digit RIR's while the majority of developed countries have negative RIRs.
• Recent Performance: All else being equal, recent underperformers vs. over performers may be more attractive investments. This allows traders to take advantage of mean reversion and the over reaction of most investors to past news.
• Subjective View on The Country: An investor does not just want a purely number driven analysis. Many different subjective factors such as the politics of the country, quality of accounting, risk of war, corruption levels, etc. should be rolled into the overall analysis; no matter how cheap a stock market is, if it is completely corrupt, no price is justified.
• Valuation of Stock Market: As with any investment, the actual valuation analysis of the country's stock market is very important to the overall process. Several different data points can be used to come up with a county stock market valuation including dividend yield, earnings yield, CAPE and the price to book ratio.
• GDP to Debt Ratio: The lower the debt to GDP ratio of a county the better. This is fairly obvious as lower debt allows easier future credit/government spending growth, much more flexibility in addressing economic problems and a lower debt burden to the population.
• GDP Growth: Obviously, all else being equal, the higher the GDP growth of a country in the future is better for the health of the economy and the stock market.
• Currency Outlook: This is one of the hardest but most important aspects of this analysis. Even if an investor was spot on in their analysis of the country itself, valuation, etc., the currency effect can overwhelm. Therefore, in analyzing the strength of the local currency one should look at many factors including real interest rates, inflation, purchasing power parity, recent performance, etc.
Using this model, Peru (NYSE: EPU), Turkey (NYSE: TUR), China (NYSE: FCHI) and Brazil (NYSE: EWZ) are some of the strongest emerging markets for investors to consider. Although since most of the countries have performed very well over the past three months or so, the strength of recommendations have come down across the board.
Eric Mancini, CFP is Director of Investment Research at Traphagen Financial Group (www.tfgllc.com).
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