From watching the action in the iShares MSCI Brazil ETF (EWZ), you might think we were back in October 2008 rather than 2014. As of Wednesday’s close, EWZ had dropped a staggering 22% in less than a month.
The “reason” for the drop in Brazilian stocks — if you can ever identify a reason for a drop of that size — is the growing probability that president Dilma Rousseff will win re-election in this Sunday’s election. Hopes had been building that Rousseff would lose to upstart Marina Silva, but the race is now too close to call, and Rousseff appears to have the momentum.
So, what are we to make of this? Is Dilma that bad?
Yes, Rousseff is a lousy president with a terrible understanding of basic economics. But let’s look past the politics here.
In a little more than three months (from late October of last year to early February of this year), EWZ dropped by about 27% before turning around and rallying by 42%. The current 22% drop is significant in that it happened in the proverbial blink of an eye, but its magnitude is nothing special. Over the past 10 years, the Brazil ETF has had 11 instances where it dropped 20% or more. And that included a period in which EWZ rose by a factor of five.
In other words, unless you have a stomach for volatility, you have no business buying this Brazil ETF.
So, after the recent rout, where does that leave us? Is EWZ a basket of cheap bargain stocks, or is it value trap better left avoided?
Let’s play with the numbers a little.
As of Wednesday’s close, EWZ is nearly 60% below its 2008 high and nearly 50% below its highs of as recently as 2011. Some of this decline has come because of the depreciation of the Brazilian real, which has lost 31% of its value relative to the dollar. The real is now sitting close to its 2008 crisis lows.
Although the real still is slightly overvalued by the back-of-the-envelope calculations of The Economist’s Big Mac Index, I don’t see it falling much lower from these levels. The U.S. dollar has been exceptionally strong since the start of the third quarter on the assumption that the Fed will be raising rates soon. While that might matter vis-à-vis the euro or yen, I don’t buy the argument for high-interest-rate countries like Brazil.
Currency issues aside, EWZ is very attractively priced at a cyclically adjusted price/earnings ratio (“CAPE”) of less than 10. Now to be fair, the 10-year average includes the inflated earnings years of the mid-2000s commodities boom. But then, it also includes the 2008 meltdown and global recession that followed.
To keep this in context, U.S. stocks trade at a CAPE of 26, near the levels of major past market peaks.
Looking at the numbers differently, let’s look at a metric that I’ve seen Warren Buffett use before as a gauge of broad market valuation (see chart above). We see that the market cap of the Brazilian stock market is worth about 44% of Brazilian GDP. As a point of comparison, the long-term average for Brazil is 57%, and the U.S., U.K., Canada and Australia all have market-cap-to-GDP ratios well in excess of 100%.
Whatever you might think of President Dilma and her policies, Brazil is cheap right now, and its recent selloff is within its historical norms.
Could there be more downside from here? Sure. But if the past is any guide, we could see EWZ jump by a quick 40% or more over the next six months and by several hundred percent over the next several years.
Charles Lewis Sizemore, CFA, is the chief investment officer of investment firm Sizemore Capital Management. As of this writing, he was long EWZ. 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.