Ignore the Selloff and Invest in International Markets in Q4

This is not a fun time to be invested outside of U.S. borders. Concerns over Fed monetary tightening — and thus dollar strengthening — have sapped investor enthusiasm for overseas markets and particularly emerging markets. But it is precisely now, when valuations are cheap and investor sentiment so one-sidedly bearish, that you should be allocating at least a portion of your portfolio internationally.

quarterly review and outlookLet’s start with valuations. I like to look at metrics like the cyclically adjusted price/earnings ratio (“CAPE”), a concept first popularized by the legendary Benjamin Graham — Warren Buffett’s mentor — and more recently by Yale economist and best-selling author Robert Shiller. The CAPE is a fantastic way to get a broad view of how a market is priced. Like all metrics, it is subject to interpretation, but I can think of no better “quick and dirty” way to judge a market’s relative value.

Meb Faber — the portfolio manager of one of my favorite ETFs, the Cambria Global Value ETF (GVAL) — does a fantastic job of compiling CAPE data from around the world. Well, Faber is at it again. In a recent research note, Faber acknowledged that CAPE has its detractors. As I myself have noted, CAPE’s usefulness as an indicator can be affected by macroeconomic factors such as bond yields. And others have noted that using historical earnings is problematic due to changes in accounting standards over the years.

Faber published a rebuttal that compares the CAPE to similar 10-year metrics for book value (CAPB), dividends (CAPD) and cash flows (CAPCF). And guess what? The results don’t look all that different. The countries that look cheap by CAPE standards generally look pretty cheap by the other metrics as well.

Still, in the interest of thorough research, we’ve constructed the following chart, which ranks the countries of the world by the average of the four metrics.

Countries by Cyclically-Adjusted Price Ratios

countries by price value

Source: The Idea Farm.

So, what do we make of all these numbers?

A couple of broad points jump off the page pretty quickly.

To start, American stocks are pricey, while most major European and emerging markets are relatively — or at least comparatively — cheap. Of the world markets tracked, only the Philippines, Indonesia and Denmark are more expensively priced that the U.S. markets.

Secondly, single metrics can be deceptive. For example, if you used the cyclically-adjusted price/dividend ratio for Russia, you would see a market that was not particularly cheap. But in looking at earnings, cash flows and book values, you see one of the cheapest markets in the world. So, it pays to look at multiple metrics when assessing a market’s valuation.

Now let’s turn to the subject of the U.S. dollar. Part of the skittishness towards non-U.S. assets of late is fear that Fed tightening will mean a much stronger dollar. But is this a reasonable fear? U.S. interest rates are still among the lowest in the world, and even by the Fed’s most aggressive estimates, short-term rates will only rise over the course of multiple years.

By the end of 2017, the Fed’s policy-setting committee expects the fed funds rate to be 3.75%. That’s three years from now, and it assumes that the economy continues to recover without any major hiccups. Meanwhile, the dollar is already fairly expensive.

Using the Economist’s Big Mac Index as a back-of-the-envelope gauge, Brazil is the only investable emerging market with a currency that can be considered “overvalued” relative to the dollar, and even here it is significantly less overvalued than in recent years.

Among developed markets, the U.K. and eurozone are roughly fairly valued relative to the dollar. Loose monetary policy from the ECB could send the euro lower, of course, but we’re starting at a reasonably-priced base.

How should we use this information to invest in the fourth quarter? I am by no means bearish on U.S. stocks, and I don’t necessarily expect a major correction in the next few months. But I do believe that U.S. stocks are priced to deliver disappointing returns going forward. Meanwhile, there are real values to be had elsewhere in the world, particularly in countries that have recently emerged from financial or political crisis.

If you want a nice “one-stop shop” for underpriced foreign markets, I recommend Faber’s GVAL. Its largest country weightings are a “who’s who” list of the cheapest markets in the world; Brazil, Spain, Austria, Italy, Ireland, Israel and Russia all have 10%-11% weightings.

If you want to choose individual markets, I am most bullish on Spain, Brazil and Russia. Emerging markets look particularly attractive. The easiest ways to get access to these markets are via the iShares MSCI Spain ETF (EWP), the iShares MSCI Brazil ETF (EWZ) and the Market Vectors Russia ETF (RSX).

Brazil is in the midst of a contentious presidential election and Russia … well, Russia is Russia. I expect to see some fairly wild price swings in these two emerging markets in particular. But I also consider both priced to deliver fantastic returns going forward for investors with the patience and intestinal fortitude to ride out the volatility.

Charles Lewis Sizemore, CFA, is the editor of Macro Trend Investor and chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he was long EWP, EWZ, GVAL and RSX. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays.

Article printed from InvestorPlace Media, https://investorplace.com/2014/09/emerging-markets-etfs-to-buy/.

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