Emerging Markets: Value Opportunity or Trap?

by Daniel Putnam | January 15, 2014 8:17 am

Stocks in emerging markets might look like a value opportunity at present — in fact, they’re undeniably cheap.

But they’re also cheap for a reason — meaning that investors are better off keeping their powder dry than jumping into an asset class where the risks outweigh the rewards.

Emerging Markets Trading at a Deep Discount

As mentioned, valuations for emerging markets are certainly compelling. USAA’s investment management wing, which has quietly amassed over $57 billion in assets under management, makes the valuation case for the emerging markets in its 2014 Investment Outlook[1]. The company notes:

“The price-earnings ratio for U.S. small-cap stocks … jumped 25% in 2013. In Europe, the P/E ratio rose 20%, and U.S. large caps increased nearly 18%. Emerging markets’ P/E, on the other hand, slipped about 2%.”

The result, according to USAA, is that emerging markets now feature valuations well below that of the emerging world: The MSCI Emerging Markets Index closed 2013 with a P/E of 10, versus 13.5 for the developed-market MSCI EAFE and 15 for the S&P 500.

These low valuations are reflected in ETF Database’s list of the 100 ETFs[2] with the lowest P/E ratios. No fewer than 19 of the top 25 ETFs on the list are invested in emerging markets. The lowest in the category is the Market Vectors Russia Small-Cap ETF (RSXJ[3]), with a P/E of just 4.85.

These valuations obscure the fact that the emerging markets retain their growth advantage relative to the developed world. Although the rate of change in the developed markets is more favorable — heading up instead of down — the emerging world continues to a grow at an annual rate about 3 percentage points above the developed countries. And if growth in established economies indeed picks up, that should feed directly into the growth rate of emerging markets.

Faster growth, lower valuations: It seems like the ideal combination, especially with investment dollars continuing to slosh through the global financial system in search of opportunities. And in time, it will be — but not yet.

Two Key Headwinds Argue for a Wait-and-See Approach

Emerging-market stocks are vulnerable to two sources of headline risk that could cause values to become even more attractive at some point later in the year.

Add it up, and the downside risks continue to outweigh the potential upside in emerging market stocks.

This is underscored by the chart of the Vanguard FTSE Emerging Markets ETF (VWO[11]), which can’t make sustained headway and is still dangerously close to its long-term support near $35. The ETF still was at $39.81 on Tuesday morning, meaning the VWO still has around 13% to fall before breaking down, but that cushion is less than the 17% drop the ETF suffered in its six-week downturn last spring.


Bottom Line

Keep your powder dry, and be careful not to interpret short-term rallies as an “all-clear” signal. At some point in the next six months, emerging markets will provide an opportunity to take advantage of the valuation disparity versus their developed-market counterparts, but that time isn’t here just yet.

Wait for the other shoe to drop before committing fresh capital to emerging markets.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

  1. 2014 Investment Outlook: https://communities.usaa.com/t5/Market-Commentary/USAA-s-Investment-Outlook-for-2014/ba-p/13287
  2. 100 ETFs: http://etfdb.com/compare/lowest-pe-ratio/
  3. RSXJ: http://studio-5.financialcontent.com/investplace/quote?Symbol=RSXJ
  4. EEM: http://studio-5.financialcontent.com/investplace/quote?Symbol=EEM
  5. EWZ: http://studio-5.financialcontent.com/investplace/quote?Symbol=EWZ
  6. TUR: http://studio-5.financialcontent.com/investplace/quote?Symbol=TUR
  7. EIDO: http://studio-5.financialcontent.com/investplace/quote?Symbol=EIDO
  8. THD: http://studio-5.financialcontent.com/investplace/quote?Symbol=THD
  9. EZA: http://studio-5.financialcontent.com/investplace/quote?Symbol=EZA
  10. EPI: http://studio-5.financialcontent.com/investplace/quote?Symbol=EPI
  11. VWO: http://studio-5.financialcontent.com/investplace/quote?Symbol=VWO
  12. [Image]: http://investorplace.com/wp-content/uploads/2014/01/eem.gif

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