Look, American stock markets are pretty expensive right about now.
We know that, and so do lots of other people. In fact, everyone’s talking about it, which is kind of scary.
On Wednesday, we looked at Jeremy Grantham again.
He mentioned two places still worth investors’ time and attention. Hiding places for worried investors.
On Wednesday we discussed the greening of the economy, which in his words will have growth rates which “dwarf” the rest of the global economy.
The other, which I want to investigate today, is emerging markets (EM) value.
This stuff does look incredibly cheap next to everything else, but does it really offer protection if American markets crash?
Firstly, why are people looking at EM value stocks?
Because US stocks are at record valuations vs history (the highest ever market cap-to-GDP reading was… drum roll please… this week.)
Meanwhile, value stocks have seen record underperformance over the last two decades. Growth has dominated – especially for US big tech like Netflix, Amazon, Facebook, Google, and, er, GameStop I guess.
And emerging markets have also underperformed the US.
So EM value is kind of like the anti-bubble. It’s all the stuff that’s not gone up. Geographic and strategic underperformance has created a landscape strewn with bargains and littered with attractive yields.
Basically, it’s well cheap. Especially relative to the US, and tech, and growth. (Those are mostly the same thing but not entirely.)
How cheap? Well, the MSCI Emerging Markets Index trades at 16 times expected earnings in the next 12 months. The current price-to-earnings (PE) ratio of the S&P 500 is 38.8x(!!).
I have a few problems with this thesis.
The first is this. If you got to EM value by discovering, lo and behold, that US stocks are overvalued and likely to be brought back down to earth when sentiment turns against them, then you have to also believe that EM value can provide protection in that scenario.
That if US markets crash, your already unloved EM value can retain its value better than cash, gold, or some other protective asset.
I would be cautious of such a view, and here’s why.
Historically, emerging markets have failed to offer any resistance when US markets crash.
Below is a pretty random basket of emerging market indices, chalked up against the S&P 500 between 2006 and 2011.
The S&P is the shaded blue area. You can see that they rise and fall in near unison. This is like paying the Teletubbies for protection.
The same basket of indices is shown again below, this time around the dotcom bubble and bust:
A few stocks didn’t have data going back to 2000 and so don’t show up.
But you can see a broadly similar picture, albeit slightly less perfect in 2006-2010.
From around the time that US markets peak, it takes its friends along for a race to the bottom.
Like a peloton in the Tour de France, when a bike near the front flips over its front wheel, it’s pretty hard for the rest to swerve the trouble. Carnage often ensues.
Skiing provides plenty of analogous pile-ups too.
Historically, emerging markets have had a positive correlation with US markets during bear markets.
They’ve had a beta of around 1 with American markets. That is to say they fall broadly the same amount as the US. Some fall more, some less, but overall, emerging markets have not tended to offer anti-correlation when you need it most.
In the last bear market, during the Great Recession, the Vanguard 500 Index Investor fund (VFINX) fell 55%. The Vanguard Emerging Markets Stock Index fund (VEIEX) tumbled 61%.
That would be a beta of just over 1. (Negative beta would be what you’re after in this scenario – something which goes up when other things go down.)
There are fundamental reasons why this should be true as well. Take the “Corona Crash”, for example.
Stage one – US stocks crash. What are people selling into? Cash ($$$). The dollar strengthens.
Currency lingo is annoying. Strengthening = falling on a chart. Sometimes. (USD-EUR ≠ EUR-USD, eurgh. This is why I rarely go into this stuff. But it’s really important this time! So bear with me. I’m sorry.)
Basically, the dollar strengthening against EM currencies means that it takes more of them to buy a single dollar.
An example would be that before the crash, you could buy a dollar with 3,400 Colombian pesos. A month later, you needed 4,000 Colombian pesos. See below (USD-COP):
That spike was in March. Financial assets converted into dollars. The dollar strengthens.
And what happens to emerging markets?
Their interest burdens go up in their own currency.
Let us say Colombia has borrowed money from the US – 10 million US Treasuries worth $100 each.
Very simplistically, let’s imagine that somehow, the bond price and yield do not move during this crash (this wouldn’t happen).
The interest burden was 1%, so $1 million per year. In February, the Colombian government had to convert 3.4 billion pesos into dollars to pay that off (3,400 x $1 million).
In March, after the dollar strengthened, this interest burden rose to 4 billion pesos.
Another 600 million pesos!
The outlook for Colombian bonds and equities is worse when the government’s debt burden rises. Maybe it has to increase taxes, or print more money which devalues the currency.
Argentina has simply defaulted on its debts, nine times in the last 200 years I believe.
These are the currency dynamics by which a crash in US stocks automatically makes life harder for emerging markets.
So historically, and logically, emerging markets aren’t the best bet if you think US overvaluations will end in tears.
If you think that US stocks will simply plateau with value stocks in emerging markets play catch up… then… fine I guess.
There’s some logic to it.
Or that EM value will surge as the vaccines roll out, economies will spurt back into growth, and the dollar will continue to fall. This is a plausible scenario, which may play out this year if US markets don’t crash.
I think that the US markets will tank, but as I remind myself, an investor shouldn’t be more than 60% confident, about anything.
So as part of a low-conviction play, perhaps EM value has a place.
But don’t go thinking it’s a good place to hide in a crisis.
To quote one of the wisest investors out there, “emerging markets are just markets you can’t emerge from in a crisis”.
The interesting thing about Grantham name dropping EM value alongside green economy stocks is this.
They are total opposites.
The green economy is potentially the highest growth opportunity in a low-growth world.
EM value is the deepest value in an overpriced world.
So they offer very different things, and will likely benefit from different scenarios.
Even in hiding, diversification still matters.
Neither is likely to sail calmly through a crash, but both are likely to be wonderful long-lasting trends throughout the 2020s and beyond.
See you on the other side,
Editor, UK Uncensored