October 2, 2014

Dear Investor:

Although the S&P 500 has only fallen 2.3% percent from its all-time highs, international stocks (including emerging markets) have fallen nearly 10%. This “stealth” correction, obscured by the solid performance of the major domestic indices, provides major opportunity.

Emerging markets are now trading at 12 times projected earnings and only 6 times operating cash flow. For comparison’s sake, the S&P comparables are 18 and 8 respectively. NYC real estate is selling at approximately 35 times net earnings and 20 times operating cash flow. Theoretically, emerging market equities should trade at a premium to domestic companies and real estate. After all, emerging market growth eclipses U.S. prospects. For the first decade of this century emerging markets did trade at a higher multiple. Now the situations are reversed.

By inverting the P/E ratio, we can see that the earnings yields on these major asset classes are as follows:

Emerging Market Stocks: 8.3%
Domestic Stocks: 5.6%
Real Estate: 2.9%

As has happened time and time again when a sector gets too expensive relative to its peers, be it tech in 1999, energy in 2007 or Asian stocks in 2011, reversion to the mean tumbles it into humility. Emerging market stocks, from Latin America to India to China, have all seen a return to value pricing.

The ostensible reasons are many: slowing Chinese growth and Russia-Ukraine tensions both claim credit. The newest nail in the Asian stock market coffin is recent rioting in Hong Kong, which calls into question the vaunted “one country two systems” formula enshrined when China gained sovereignty in 1997. But the pendulum always swings too far: emerging markets are now priced for perdition while U.S. stocks are fairly valued and NYC real estate is in bubble territory. No matter the political situation in these countries, good quality emerging market stocks (many of whom do most of their business in the U.S. anyway) will continue to grow in aggregate—and at higher rates than domestic companies.

As values continue to present themselves, I will add to our (still relatively modest) emerging market weightings in accounts where suitable. At an 8.3% earning yield—no matter the growth prospects—the price is right.