July 12, 2019
Emerging market and other value stocks continue to lag the S&P 500 over the past 18 months. But this obscures a seachange in leadership since the bear market in autumn of last year. During the first nine months of 2018, the S&P 500 obliterated emerging markets stocks, with the S&P 500 exchange-traded fund (SPY) returning +10.36% and the emerging markets exchange-traded fund (SCHE) actually losing 7.98%. This massive disparity is nearly unprecedented in modern times and left emerging market stocks trading at bargain-basement levels, while also leaving S&P 500 stocks overpriced. The one thing you can always count on in markets is that returns revert to the mean. And that’s been happening since October 1st of 2018.
From then until June 30th, the SCHE has returned +5.41%, more than double the +2.32% of the SPY. This subtle shift in leadership has been obscured by the fact that over an 18-month period the S&P 500 has still vanquished all other asset classes. But as potently illustrated by the returns since October 1st, the extraordinary values in emerging market stocks are finally starting to make themselves heard. Mean reversion is still with us; as an inalienable law of economics, it can never be repealed. Since the fall of 2018, the emerging market stocks are outperforming the US domestic stocks that have powered the S&P for so long.
I believe this reversion to the mean will continue, with emerging market stocks eclipsing the S&P 500 over the coming three to five years, but I don’t count on mean reversion for my analysis. Instead, you need only look at value. Emerging market stocks trade at 12 times prospective earnings, while the S&P 500 trades at 18 times. Both should trade at an average of 14 to 16 times earnings, a fact which implies that emerging market stocks are significantly undervalued, while the S&P 500 is proportionately overvalued.
This suggests a much higher expected return on emerging market stocks relative to the S&P 500, not just over the next three to five years but probably over the next decade. It has been a difficult time for investors (like us) in international stocks and value stocks, the only asset classes that still show potential and high projected returns, and this difficult time has been exacerbated by the fact that the S&P 500 has done so well in comparison. But by looking at the divide between the first three quarters of 2018 and the three following, you can see that a sizeable shift is in the making. Investors will still need patience for this reversion to the mean to follow through, but history says it will. The worst thing an investor can do here is get whipsawed by switching strategies and chasing past results. In other words, don’t fight the last war, fight the next one.
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Best wishes for the coming quarter.