Skip to main content

The financial markets have been on a wild ride the past few weeks as investors worry that the mess in subprime mortgages will lead to an overall credit crunch and, eventually, a recession.

For now, at least, it looks as if that fate will be avoided.

So with stocks a lot cheaper than they were just a few weeks ago, bargain-hunters are out in force. But what is really a bargain, and what was really overpriced to begin with and now is just slightly less so?

First, let's examine how much some of the major exchange-traded funds have been marked down.

The table below shows the change in price between the recent highs, reached on July 19 and August 31, for select domestic and international ETFs.

The large-cap

S&P 500 SPDR

(SPY) - Get Free Report

fared better than did ETFs that track small- and mid-cap stocks. But surprisingly, it is ETFs of foreign stocks -- precisely those that, for the most part, have nothing to do with our subprime mess -- that are still down the most.



(EFA) - Get Free Report

ETF, which tracks foreign stocks in developed economies, was down 11.2%, while the

iShares MSCI Emerging Markets

(EEM) - Get Free Report

fund was down as much as 15.9%.

Is this a buying opportunity? I think so, but of course there's more to bargain-hunting than just buying the funds that are down the most and hoping that they'll be the ones to bounce back the most.

Some of them are down as a result of "irrational apathy" on the part of investors, while others are down for good reason.

For instance, among domestic funds, you would expect that small- and mid-cap stocks would suffer more in a credit crunch, since they generally have weaker balance sheets and are less able to weather a funding crisis. Therefore, if a general credit crunch is not going to materialize, then it would seem logical that these stocks would snap back.

But bargain-hunters should think twice. Small- and mid-cap stocks are still considerably more expensive than the large-cap

S&P 500

: the

S&P 400 MidCap SPDR

(MDY) - Get Free Report

is trading at over 18 times expected 2007 earnings per share, compared with just 15.6 times for the S&P 500, while the small-cap stocks in the

iShares Russell 2000

(IWM) - Get Free Report

ETF are still trading at almost 24 times expected 2007 EPS.

These lofty valuations are a headwind on future appreciation.

In any case, the two indices are likely to suffer the most during an eventual recession (whether this is brought on by a credit crunch or not), since they are heavily concentrated in the very cyclical consumer discretionary sector.

Therefore, investors using a "buy on the dips" strategy should probably focus instead on large-cap stock ETFs such as the S&P 500 SPDR.

However, it seems odd that the two foreign-stock ETFs in our study should have fallen as much as they did, since the companies they hold are not only less exposed to any credit crunch here but are also, as the chart shows, cheaper than their large-cap counterparts here in the U.S. (using the S&P 500 as a proxy).

I think that both of these funds (or more specifically the stocks held by these funds), which are still big winners on the year, were sold by nervous traders who needed to raise cash.

At any rate, this looks like an excellent opportunity to buy the iShares MSCI Emerging Markets ETF, one of the biggest losers during the recent correction, even if shares have already recovered some lost ground. Not only are these stocks perhaps most removed from our subprime problems, they are also the cheapest at just 13.9 times expected 2007 EPS, despite earnings growth rates roughly double those of the S&P 500, both this year and next!

We're a little less sanguine about the developed-economy stocks in the iShares MSCI EAFE ETF. (EAFE stands for Europe, Australasia and the Far East.) Though somewhat cheaper than the S&P 500 in terms of

price-to-earnings ratio, companies in this Japan-heavy index are also consistently less profitable than their U.S. counterparts -- and therefore will likely grow earnings at a slower rate in the future. That implies the discount is at least in part deserved. Still, I am not negative on EFA and believe that investors following a "buy on the dips" strategy should include this fund. However, we would not "back up the truck" to add more than you're adding in the S&P 500.

Small-, Mid-Cap Valuations Still Lofty
Price-to-earnings ratio on estimated 2007 EPS

Michael Krause is president and founder of AltaVista Independent Research. AltaVista provides fundamentally driven analysis of exchange-traded funds to help investors select ETFs based on investment merit, much the same way they would evaluate a single stock. The firm offers both print and online ETF research to subscribers, but does not manage clients' money. Mr. Krause is also a frequent contributor to broadcast and print media.