Current Valuation Gap Suggests Good Times Ahead For Emerging Markets

Emerging markets are looking like a strong buy at current levels.
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For years, emerging markets equities have been dead money. Over the past decade, emerging markets have earned a scant 2% annually, falling far behind the returns of the S&P 500 and exhibiting higher risk in the process.

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But times might finally be changing.

Emerging markets have usually had higher forecasted economic growth rates, but that hasn't translated into higher returns for a while. Relative value compared to the S&P 500, on the other hand, has had some predictive power in forecasting emerging markets outperformance.

Generally speaking, the wider the gap between the price/earnings ratio on the S&P 500 and the price/earnings ratio on emerging markets, the greater the outperformance for emerging markets over the next several years.

Take a look at the current P/E ratios of these two groups over the past 15 years.

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Emerging markets currently trade at one of the largest discounts to U.S. stocks in recent memory. As you can see, EM has traded at a wide discount for some time and that hasn't turned into outperformance.

But here are a few reasons why it could be different over the next few years.

Value

The chart above says the current gap is more than 50%, but if you look at the P/E ratios of the iShares MSCI Emerging Markets ETF (EEM) and the iShares S&P 500 ETF (IVV) - using the same issuer so we know they're calculated the same way - the gap is more like 30-35%. Either way, it's large.

A study by WisdomTree suggested that when the valuation gap falls in that range, emerging markets outperform the S&P 500 by more than 10% annually over the following 5 years.

Of course, it's no guarantee, but I like the position that emerging markets are in right now.

Falling Dollar

The dollar index is already at 2-year lows and down more than 10% from its 2020 peak. With debt loads continuing to climb and the post-COVID economic recovery in the U.S. still facing a great deal of uncertainty, I expect the value of the dollar to continue falling here.

That would be a positive for emerging markets.

Economic Rebound

If a COVID vaccine leads to a broad economic rebound, that presents a favorable environment for both value stocks and cyclicals, two areas that tend to be heavily overweighted in emerging markets portfolios.

Both of these groups tend to outperform coming out of economic bottoms and early evidence suggests it's happening again here in November.

Conclusion

All in all, this is a very favorable environment for emerging markets stocks. Volatility will likely remain high and investors should expect to buy-and-hold for multiple years in order to achieve outsized returns, but I would be overweight emerging markets stocks in my portfolio here.