Emerging Markets: Negative Stories and Valuation

Earlier this summer, we discussed some of the challenges facing Emerging Market economies such as India, Brazil, and China, notably the fact that the “low hanging fruit” had been picked in these countries economically and that the next stage of economic development would require a commitment to addressing infrastructure deficiencies, worker education and productivity, political accountability, and other issues such as the costs associated with environmental degradation.  Of course, in recent weeks, the rout in emerging market currencies, not to mention risk markets, has captured the attention of the financial world.  While the Indian rupee, for instance, has shown a little backbone today, since early May the rupee has fallen approximately 20% in value versus the US dollar.  Going back to the summer of 2011, the fall totals approximately 45%.   The Brazilian real has shown a similar dynamic.  Remember, it wasn’t so long ago that Brazilian government officials were complaining about a potential global currency war as the real appreciated too much for comfort.  Now foreign capital is exiting emerging markets rapidly.  Perhaps we can blame the QE/tapering cycle in the US.  Whatever the reason, emerging market officials face an unpalatable series of choices right now, such as raising interest rates to defend currencies just at the moment economic growth is sputtering.

Warren Buffett famously said, “You never know who’s swimming naked until the tide goes out.”  It’s becoming apparent that many economic issues in the emerging markets over the past decade were papered over by the fact that foreign money was pouring into the economies and markets and the fact that commodity prices were rising.  The Warren Buffett quote is apt in this situation.  

On that note, we were struck by an op-ed piece in yesterday’s Financial Times by Peterson Institute for International Economics fellow Anders Aslund that succinctly addressed the issue.  Titled, “Now the Brics Party Is Over, They Must Wind Down the State’s Role,” it’s a great short read to give a sense of how the governments in many of these countries squandered the economic gifts given to them over the past decade to prepare their economies to achieve higher levels of economic prosperity in future decades.  A few quotes from the article stand out:

• “During their years of plenty, the Brics did not have to make hard choices.  Today, their entrenched elites seem neither inclined to nor able to do so.” 
• “Governance is mediocre at best, reflecting substantial corruption and poor business environments…The World Bank compiles its ease of doing business index for 185 countries.  The Brics do even worse by this measure, with China ranking 91, Russia 112, Brazil 130, and India 132.”
• “Their ability to get going again rests on their ability to carry through reforms in grim times for which they lacked courage in a boom.”

We couldn’t agree more with these sentiments, and encourage you to read the article, the link to which is provided at the bottom of this blog post.*** 

Shifting gears to the investing angle to all of this, is all hope lost as far as emerging market equities are concerned?  We’ve spoken on numerous occasions about not confusing the negative or positive “stories” surrounding various political and economic dynamics around the world with future equity market performance.  As we’ve mentioned in many cases, there’s oftentimes a “darkest before the dawn” aspect to equity market investing; the bad stories are often already captured in equity market prices, and in turn represented by low valuations.  Certainly, the hardest thing to do, however, is make a commitment to equity market investment opportunities trading at very low valuations while a bunch of bad news circles a particular stock, a particular sector, or a country/region.  This is no different than the dilemma many investors face resisting the temptation to chase an expensive stock or other investment because the surrounding story is so deliciously wonderful.

The issues facing many emerging market economies are daunting for sure, as captured well in the above linked essay.  Yet, the MSCI Emerging Markets Index is now plumbing long-term valuation levels not seen since the dark days of the global financial crisis.  Currently, the index is trading at 14x on a 10-year normalized basis, the lowest since March 2009.  Emerging market equities have gone nowhere for 4 years.  As we’ve mentioned before, even the EAFE developed markets ex US index, which holds a healthy dose of European exposure, has trounced the emerging markets index.  Who saw that coming?

As such, we think this is a good time to start keeping an eye on this segment of the market, even if the news flow may get worse from here.  From a technical analysis standpoint, we think there is a decent probability for more downside in prices; it may not be time to catch a falling knife just yet.  And, fundamentally, there’s nothing out there that says an index trading at 14x can’t go to 8x.  Investors have seen that story many, many times.  But, again, don’t let the negative news flow keep emerging market equities out of the investing consciousness.  At some point, emerging market equities will find price stabilization and provide outsized returns, in our opinion, relative to developed markets.  Even now, at 14x versus 18x in the EAFE and 22x in the S&P 500, a strong case can already be made that 10-year future annualized returns could be much stronger here than in developed market equities for those willing to patiently endure some potential bumps in the road. 

We’ll see how it all shakes out, but it will be interesting to look back on this moment in several years to see if, once again, valuation trumps conventional wisdom.   

FINANCIAL TIMES OP-ED - 08-22-13

More Numbers: Long-Term P/E and Future Returns

In past notes we’ve referenced long-term, 10-year normalized P/E ratios and the relationship to future 10-year annualized returns.  With the 10-year P/E in the United States currently near 23x, we thought it might be interesting to look at outcomes when P/E ratios fell in a narrower range.  In this case, we’ve focused on monthly P/E outcomes between 20x and 25x in an attempt to see how markets performed over the following 10 years on an annualized basis in valuation environments similar to the current one. 

As in the past, we’ve used the Shiller earnings database as the basis for the normalized earnings calculation.  For consistency, we’ve used real, total annualized 10-year returns (i.e. adjusted for inflation and including dividends).  Finally, we use monthly observations from January 1925 to July 2003, the last month for which we can derive a 10-year performance number.  Over that time period, there were 154 monthly observations with a P/E ratio between 20x and 25x out of a total of 943 monthly observations.  

First, let’s look at the basic descriptive statistics for 10-year annualized returns following a P/E observation in this range:

AVERAGE      2.01%

MEDIAN         1.05%

MAX               8.72%

MIN               -3.23%

STDEV           3.78%

The results above compare to a median total return of 6.32% and an average total real return of 5.72% across the entire period from 1925 to July, 2003.  Therefore, we can make a very surface observation that valuation environments similar to the current one in the US have generated decidedly subpar performance over the ensuing 10 years.  

However, looking at a basic histogram of the performance data points for valuations between 20x and 25x presents a more complicated view point:

As you can see, the histogram shows a number of results clustered in the “tails” so to speak.  Instead of seeing a distribution with the bulk of the outcomes in the middle, results between 20x and 25x have tended to come out somewhat extreme.  Approximately 75% of the observations either come in outright negative, or greater than 5.5% annualized.  

Does this mean that making forward performance conclusions based upon valuations in this range is a fruitless exercise, i.e. it’s easy to say performance could be really decent or really bad?

Not necessarily, in our view.  Digging even deeper, we find it instructive to look at the time periods in which the observations occurred.  

Every single P/E observation between 20x and 25x generating future 10-year returns greater than 5.5% per annum (the right side of the histogram) occurred in the early to mid-1990s.  Of course, the 10-year return profile for each one of these observations captured what may be the robust bull market run in history during the late 90s.  Even though markets declined from 2000-2002, the positive effect of the late 90s bull outweighs the negative effects of the subsequent bear market. 

On the flip side, many of the most negative 10-year return observations followed P/Es between 20x and 25x observed in the mid to late 1960s.  Thus, those return profiles capture the effects of the ugly “stagflation” period experienced in the 1970s.  

The “middle” observations in the histogram occurred across a number of years in the 20s, 30s, 60s, and 2000s, capturing a wider range of economic environments, from deflation to normal inflation, robust economic growth to depression, and geopolitical uncertainty to relative normalcy.  

What do we conclude in the end?  Excluding the data points from the 1990s incorporating the massive late 1990s bull market spike, every other P/E observation between 20x and 25x produced sub-median/sub-average 10-year forward annualized returns.  Unless the markets are getting ready to experience another massive market spike like the one experienced in the late 1990s, a result of an incredibly unique set of market circumstances such as the emergence of the internet, a robust nominal and real GDP environment, and other factors, we’d wager that the real return profile for the next 10-years will look more like the less than inspiring outcomes in the middle or left side of the histogram.  Of course, as we’ve observed in the past, return patters within those 10-year periods can be quite lumpy and can produce many opportunities for bulls and bears alike.  For instance, real total annualized returns from June 2003 to June 2013 came in at a sub-median 4.19% annualized.  Over that period, though, we observed a solid cyclical bull market from 2003 to 2007/2008, a massively devastating bear market during 2008/2009, then a robust bull market from 2009 to the present.  Others periods in that return range produced similar patterns.  Thus, it’s not a stretch to believe markets will face some more lumpy down and up periods over the next 10-years producing “ok” but not fantastic real returns.  And, in light of the fact that long-term valuations are within the higher range of the historical record, we’re skeptical of talk that markets have entered a new robust, multi-decade secular bull phase.  Finally, as a reminder, ignore skeptics that tell you the 10-year P/E ratio is “invalid” because it incorporates the massive profit down-spike of ‘08/’09.  In reality, the current real 10-year trailing earnings number is currently at an all-time high, not to mention it is currently at a level significantly above the long-term trend line, as shown below.  

Strong through July = ?

Through the end of the July, the S&P 500 in the US posted simple (ex-dividend) returns of 18.2%.  Interestingly, this represents the 8^th best yearly return for the first seven months of a year in the 64 instances going back to, and including, 1950.  This also represents the strongest performance through July of any year since 1997.

How do returns typically shake out the remainder of the year after a strong start through the early summer months?

Returns have shown consistent strength during the final months in years with strong positive performance through July.  

Prior to this year, there were 20 years, roughly one-third of the years captured in this exercise, with January to July returns exceeding 10%.  In 20 out of 21 instances, returns were positive for the remainder of the year.  1987 proved to be the only exception with a -22.46% August to December loss, reflecting the carnage of the October 1987 crash.  1987, though, also produced the best returns for the first seven months in the entire sample, up 31.6%.  

For the years with 10%+ returns over the first seven months of the year, average return for the final five months is 5.16% and median return is 4.19%.  

Overall, the direction of performance through July (positive or negative) has corresponded with performance in the final fall/winter months of the year.  The deck is stacked, though.  There were only 17 years out of 63 in which the direction of performance for the final months differed from the direction for the months through July (i.e. negative final months vs. positive first seven months and vice versa).  However, as mentioned, only one of the years in the top 20 (1987) showed this divergence, meaning that in 16 of the 43 years outside the top 20 (almost 40%), the direction in the final months reversed.

What are the quick takeaways?  First, as always, a disclaimer: past isn’t prologue.  Just because the record has been so consistent doesn’t mean the bottom can’t fall out the remainder of the year.  Second, and obvious, it’s remarkable how consistently strong the continuation pattern is for years with very strong starts.  This continuation has occurred during vastly different market valuation environments, for instance.  The maximum 10-year P/E at the end of July among the top 20 performance instances was an extreme 35.4x in 1998; the minimum was 9x in 1980.  The average mid-year normalized 10 year P/E for the top-20 years was 18.2x and the median was 18x, above the long-term average of 17.5x and long-term median of 16.5x.  Thus, one can’t attribute the phenomenon to extremely low valuations or washed out periods.  Perhaps, market psychology takes over during the “strong start” years and performance chasing becomes pervasive, carrying returns in the subsequent months.  16 of the top-20 years (prior to this year) occurred during secular bull periods.  However, only three of those 16 secular bull occurrences, 1997, 1998, and 1967, fall at or near the very end of the secular bull cycle, periods generally associated with parabolic upward moves as the final money pours into the secular bull and optimism becomes extreme.  Similar to 2013, these could be years where disbelief in the rally, the proverbial “wall of worry”, is present and portfolio managers and individuals are hurrying to play catch up.  On that note, we only have AAII bull/bear data since the middle of 1997; in the seven instances in the top-20 starts with bull/bear data, all seven showed bulls exceeding bears at the end of July, maybe undercutting the “wall of worry” notion.  

Nonetheless, it’s an interesting bit of persistence, and could provide some hope for the remaining fall and winter months that the good times will last, even in the face of higher than average long-term valuations.

1950 to 2013: Years with 10%+ Returns through July and Subsequent Returns

The Dogma and the Damage Done

The furious rally over the past month in US and global stocks, not to mention the consistent rally and cyclical bull present over the past few years, prompts us to remind you of a few simple truths:

• The market doesn’t care what you believe.  The greatest, most soundly-constructed thesis in history can prove to be the biggest money loser.
• Markets can go up (or down) for a lot longer than you think.
• Markets are structured to serve the greatest amount of pain to the greatest number of people at any given point in time.  

Recent history provides another example.  Several weeks ago as the markets reached the lowest points during the June correction, we noted that internal market sentiment captured among several indicators had reached some of the most bearish levels since the depths of the global financial crisis.  In the past, we’ve discussed the “pain trade.” This has become the pain trade extraordinaire.  We were amazed that such a shallow correction (in the grand arc of market history) had generated such negative sentiment so quickly.  Of course the broad based fear coalesced around several widely discussed themes, including Fed tapering, China woes, new Europe troubles, a decelerating US economy, earnings stagnation; the list could go on and on.  Over the past few years, the broader arguments, and they’ve been forceful and logical, center on decline and stagnation in Western markets, especially Europe, destructive inflationary policymaking, asset bubbles, overvaluation, currency wars, political issues, etc.  

In the wake of the upward move, we keep hearing the usual retorts: central banks are blowing bubbles; economic growth doesn’t support equity market gains; markets are manipulated; higher interest rates will kill the rally; markets are overbought; markets are overvalued; good news is priced in; earnings fundamentals don’t support higher prices; Congress is good/bad; the President is good/bad; the Fed and ECB are good/bad.  

Perhaps some or all of these arguments are correct.  Suffice to say, we’d agree with some of the arguments, such as the fact that US markets are trading above median valuations on a long-term basis.  From a market timing standpoint, however, these arguments are irrelevant.  In the case of long-term valuation, the market has certainly traded at levels such as the levels currently observed without experiencing a major negative episode in the immediate future.  

All of this reminds us there are two broad mistakes many investors make over the long run: 

First, many investors have a sound, objective thesis, based on solid data, but they express the thesis too early in the cycle.  Some investors have the experience and fortitude to carry the position to a profitable conclusion.  Most, however, find themselves unable to hold the line psychologically; often, positions are abandoned at the worst possible moment, right before the thesis is ready to play out.  The pain is too great.  Many value investors, for instance, were correct in pointing out how overvalued the market was in 1998 and 1999.  Unfortunately for many, the market continued its relentless rise.  Numerous investors threw in the towel at the beginning of 2000 and chased growth, only to watch growth names crater for two years.  Of course, similar decisions take place at market bottoms, such as the bottom witnessed in March 2009.  Investors picked up stocks on the cheap during the fall or winter of ’08, only to watch stocks make new lows a few months later.  Fear and volatility were high.  Many potentially profitable positions were dumped right before markets began rising relentlessly.  

Second, and more dangerous, investors make decisions based upon political leanings, economic theories, or similar drivers.  We’ll call this the “dogma” trade.  In many cases, markets begin moving in a direction contrary to the direction predicted by the theory.  Investors then engage in confirmation bias type behavior, seeking opinions from analysts, writers, friends, and others that reinforce prior opinions.  The further markets move, the more hardened opinion becomes.  Blame is assigned to forces perceived to be outside the investors’ control.  We see these types of investment decisions expressed each political cycle, for instance.  “XYZ” political party spells doom for markets or presents the greatest opportunity in the history of market time.  “XYZ” presidential candidate means the end of the world as we know it or the greatest leader in the history of time.  John Q. Smith Fed Chairman is either the savior of the world or the world’s most dangerous economist.  “Insert economic theory” is the key to understanding why markets are prepared to rise or fall 80%.  

What to do to mitigate these consistently problematic errors (easier said than done in today’s info-saturated world)?

• Never, ever, ever base an investment decision on ephemeral qualitative factors, such as political or economic beliefs.  Never let a political or economic stance color or guide enthusiasm or distaste for a course of action.  Shun advice from pundits, TV talking heads, etc.  Immediately run away from advice that the election or defeat of “so and so” is good or bad for markets.  In the economic realm, always be wary of “this time is different” arguments.  The past two decades are littered with economic and political investment justifications that proved extremely detrimental to investment success.

• Express immediate skepticism over highly concentrated consensus views.  If every newspaper, magazine, and business show in the country is touting something as a “can’t miss” opportunity, there’s a very good chance that the idea has completely played out.  Highly publicized and touted ideas deserve deeper scrutiny than other opportunities as far as valuation and future growth forecasts are concerned. 

• A corollary: never make decisions solely on the basis of a sell-side analyst report, a magazine article, or an article in the morning paper.  This seems obvious.  But, we’re always amazed how many decisions, even among skilled institutional investors, are made on the basis of these types of sources.  Unfortunately, the pressure to chase missed opportunities is always very high.

On the contrary, DO:

• Develop, test, and use objective criteria such as long-term, stable valuation ratios to inform decision making.  Over the long-run, valuation matters, and its relationship to long-term future returns is statistically significant.  Understand market history, the nature of risk/reward, and what constitutes an extreme valuation metric on the valuation bell curve.  Even individual investors can access this type of data easily and cheaply these days.  Buying equity markets when valuations reached single digit or near single digit levels in 1982 or 2009 didn’t feel good, but low valuations were an indication that all bad news had been priced in and that risk/reward was favorable.  Conversely, taking risk off the table or shifting into more defensive positions as markets were moving to nosebleed valuations in 1999/2000 didn’t feel particularly intelligent, but proved a lifesaver.  Of course, more often than not, valuations are within reasonable range of long-term median levels.  Ignore noise when valuations are treading in the fat part of the bell curve and remember that volatility is always a part of investing.  

• Concurrently, always develop an objective, executable plan.  For institutional investors or experienced individuals, this may involve incorporating technical analysis and/or various objective risk management techniques into a portfolio to objectively guide allocations and trading activity.  A trading system could keep someone in the markets to capture a final major up move, for instance, even though valuations are stretched.  Conversely, objective systems might help mitigate the problem of “falling knives” or netting value traps.  For those with other things to do besides watch markets all day, maybe a plan involves asset allocation strategies with regular rebalancing.  These types of strategies ensure that assets are gradually being moved towards out of favor markets and away from overvalued markets.  Understand that no plan will work in 100% of situations.  

• Avoid complex, impenetrable investment strategies and instruments.  

In the end, allowing bias and subjective ideas about how the world works, or how it should work, is a quick way to surrender assets.  Of late, we’ve seen enough missives blaming markets themselves or the policy makers supposedly shaping markets to lead us to believe that many have missed moves up in the market in recent months and years mainly due to the “dogma” error identified above.  There’s little in the investment world more frustrating than missing the good part of a market move in either direction because subjective beliefs overrode a solid objective game plan.