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.

Economic Numbers and Perspective

Last week, investors opened up newspapers (or iPad and iPhone apps or news aggregators) and learned that US retail sales were weaker than consensus, which was true.  News outlets, however, made it sound like the retail economy had really ground to a halt relative to recent experience.  They especially focused on retail sales ex auto and gas, which declined 0.06% on a month over month basis.  Take this reporting from The Wall Street Journal after the numbers were reported.  The headline blared, “Consumers Dial Back on Their Spending.”  

Consumers moderated their spending in June…the latest sign the economy is trudging through a weak patch in the middle of the year…The June report suggests consumers remain cautious about buying anything other than basics

Yes, well consumers did pull back on a month over month basis, but it’s not like spending cratered.  The month over month decline was barely a statistical blip in the grand scheme, about half a standard deviation below the historical mean for month over month ex auto and gas figures.  In any case, there’s a lot of noise around monthly figures.

Let’s take a step back and look at the year over year gains for retail sales ex auto and gas, a figure very few news outlets reported or discussed.  YoY, retail sales ex auto and gas were up 4.51%, slightly higher than the historical mean of 4.49%.  Retail sales overall were up 5.72% YoY, higher than the long-term average of 4.61%.  From that perspective, retail sales don’t look too bad.  Plus, that was the highest year over year figure for monthly retail sales ex auto and gas since December.  

Taking a broader perspective, we also know that GDP growth has remained sluggish the past several quarters.  Since Q1:2010, year over year real GDP growth has averaged 2.1%, below the long-term historical average of 3.1%.  Articles such as the one cited above commonly mention the fact that slow consumer spending and declining retail sales and hidden wallets are to blame.  Are they really?  The average monthly year over year gain for retail sales from January 2010 through the most recently reported month is 4.4%, pretty much exactly in line with the historical average.  Over the past 18 months, the average is 4.6%, above the historical average, and the over the past 12 months, the average is 4.2%, just slightly below the historical average and basically in line statistically.  

A similar situation developed in the wake of the durable goods number yesterday.  While the headline number was strong, some pointed out that the month over month non-defense capital goods, ex-air, number was sluggish.  It came in at 0.7% month over month, roughly in line with consensus while the headline number came in at 4.2% month over month.  Again, we’ve been told time and again that slack in this area of the economy is to blame for sluggish economic growth.  Again, the numbers don’t necessarily add up.  Year over year, Capital Goods Orders, ex air, ex defense were up 7.1%.  Granted, over the past 12 months, this number has been somewhat weak coming in at an average of 0.2% versus a long-term average of 3.45%.  Since January 2010, however, the average has been 8.17%, far higher than average.  

What, then, has been the biggest drag on real GDP growth over the past three years?  Government spending.  The government spending component of GDP, which accounts for government spending at all levels of government, has been pretty much dead flat since 2009.  The average quarterly year over year growth for government spending is 0.92% since January 2010 versus a long-term historical average of 7.2%.  Media notes to the contrary, the private sector in the US , while not experiencing the most robust recovery in the history of the country, has performed reasonably ok.  On the other hand, the media spends a lot of time talking about austerity on the European continent.  Austerity seems to be alive and well in America too, a good or bad thing depending on where you sit in the economic and political debate.

Nonetheless, it’s a reminder that retail sales, durable goods, and other economic numbers require a broader perspective.  In total, the economic/business press is great about whipping up sometimes dramatic headlines about short-term, noisy statistics without placing them in a longer-time-frame context.

Resilience, Adaptability and Economic Progress: The US and Chinese Examples

Watching an old multi-part PBS series recently on the turmoil during the 50s, 60s, and 70s in America led to some reflection on the broader capacity of the American system to change and adapt, both politically and economically.  Surely, the solutions to many problems in the US are far from perfect, and the political and economic systems in the US aren't immune to significant, even existential problems and conflicts as evidenced by the American Civil War, the Great Depression, the significant struggles surrounding the Civil Rights Movement and the Vietnam War, or even the recent so-called "Great Recession."  Nonetheless, time and again, the existential challenges have been faced head on, the systems have adapted, and the American people have moved on to greater levels of economic, social, and political well-being.  Depending on the magnitude of the crisis (or the magnitude of the economic bubble preceding an economic crisis), the timeframe for recovery has varied dramatically.  We've had short recoveries from economic and political crises, such as the swift recovery in the early 1990s, and extremely long and tortured recoveries, such as those witnessed during the Great Depression, the Depression in the late 1800s, or the slow recovery now.  Whatever the situation, though, the US has found a path back to prosperity and productivity.  We're quietly performing the trick again now, with economic growth in the US outpacing most other developed countries and now outpacing many of the celebrated developing nations.  Even if some of the headline economic numbers in other nations eclipse those of the US, an argument can be made that US economic growth is on a more balanced, sustainable path than many peers.  

This historical record of resilience in the US becomes particularly interesting when we think about this adaptability and progress in a global context and contrast the American experience with other nations, both developed and emerging.  It's especially notable to point out recent examples of competing states such as Japan in the 1980s, or China in recent years, that were/are supposed to supplant the US system as the most successful or prominent or dominant or biggest (or whatever superlative you want to use) within XXX number of years and at significant cost to American prosperity, well-being, and prestige.  Of course, the emergence of shiny new systems or competitors always seems to invite much teeth-gnashing and frantic calls for changes to the American political and economic system so we can ostensibly compete head on with the emerging threat, despite the fact that, as mentioned, the US system has faced and surmounted many seemingly insurmountable problems historically under many unique circumstances.  For instance, as China's ascent up the economic and geopolitical ladder accelerated over the past decade, we came across no shortage or articles, blog posts, essays, and even academic pieces arguing that the US democratic political model was ill-equipped to challenge the state-directed economic model used by the Chinese.  

Time and time again, we've missed the forest for the trees, or completely forgotten the historical record as to why exactly the US system, even with its imperfections, continues to overcome challenges.  It's happened again with China.  Just as chatter reached a fever pitch in the US in the late 1980s over the Japanese economic model right as the country was about to enter a two decade economic and political decline and crisis, chatter in the US over the past three years reached a fever pitch over the supremacy of the Chinese model just as the flaws within that model began revealing themselves.  All of a sudden, system attributes held up by analysts as virtues of the Chinese system are quickly being reevaluated as significant impediments to advancement to the next stage of economic development.  A few years ago as the US was in the depths of recession, China's ability to quickly direct substantial resources towards investment in infrastructure spending and manufacturing capacity within state owned enterprises was lauded as a magnificent success and an indictment of the western model.  Now some chickens are coming home to roost.  The consumption/investment ratio in the GDP accounts in China is significantly out of whack.  Numerous examples exist of poor investment decision making at all levels.  For instance, Industries such as steel production face incredible overcapacity.  Many state owned enterprises (SOEs), perhaps more than a quarter according to some estimates, operate in the red.  Emerging businesses face numerous impediments due to problems obtaining credit or problems navigating a political environment geared towards the favored SOEs.  Out of control credit growth, much in the so-called shadow finance system, is creating the potential for instability, with the credit to GDP ratio in China jumping past the 200% level.  Corruption among local party officials has become endemic enough to require China's new leadership regime to crack down on conspicuous consumption and corruption.  Costs from pollution and other negative externalities are piling up leading to protest and discontent.  Lack of accountability in the political system, opaque rule of law as it pertains to disputes and intellectual property, and other political factors amplify discontent and are now beginning to affect foreigners' desire to operate in the country.  The one child policy has created a potential demographic nightmare.  

Now, we get a chance again to see whether a competing system can overcome a serious set of roadblocks in order to continue the pursuit of the United States' global economic mantle.  The Japanese system proved incapable of finding a path out of the economic despair that started in the early 1990s.  The jury is still out on Abenomics in Japan, but there's no debate whatsoever anymore globally that Japan will ever overtake the US economically.  Can Chinese leaders avoid a similar fate?

We think the challenges will be extremely tough for China.  

To understand why, we need to bring the discussion back around and point out why the US system has been so resilient over time.  Politically, while messy, the US system as established by the founders works in the vast majority of cases to generate acceptable compromises and consensus, even if they do seem to come at the last hour.  A wide range of voices is usually heard.  Interest groups can express grievances.  It's doesn't mean the suggested solutions will be incorporated, but there's at least an outlet for frustration.  In any case, many problems, past mistakes, and loose ends are eventually addressed.  The system is flexible and, by design, incorporates diffuse and competing power structures allowing for a wide range of ideas.  Solutions are often reached over longer stretches of time, which is frustrating, but desirable.  The system often dilutes the potential for radical shifts in policy direction.  Overall, the political process finds its way back to the center line over time.  We as individuals or interest groups may not agree with every decision, but the political process is reasonably transparent and the path for redress is reasonably clear.  The rule of law and property rights are relatively strong, both for foreign and domestic businesses and individuals.  Economically, the system encourages entrepreneurial activity and innovative decision making.  Whatever one thinks at present, it's still much easier to start a new enterprise in the US than most other nations, especially the emerging nations.  Certainly, the nation's unique history and geography contribute mightily to the entrepreneurial culture.  Still, structures in the political economy established via laws passed over time have contributed significantly to the bottom-up economic decision making culture.  Capital allocation decisions, while distorted by political decision making in certain cases, is still vastly determined via rational economic channels and not by broader proclamations of top-down industrial policy mandates.  Decisions are generated by millions of people, not the few.  Where politics and economics intersect, such as national infrastructure policy, the positive attributes of the political system have generally pushed the country to "get it right" over time.  Take all into consideration, and the so-called "invisible hand" is given plenty of room to work its magic.  Again, sometimes it takes longer than some people desire to find the middle line, but the system eventually finds equilibrium.

Contrast this with the Chinese system at present.  Relatively few people at the top of their national and local governments direct vast amounts of resources and make decisions on broad economic and industrial policy, often by fiat or whim.  The Politburo Standing Committee, for instance, holds immense power over national political and economic life.  Local officials are appointed and likewise wield significant power of resource allocation and political direction.  Again, these leaders are not elected and aren't directly accountable to individuals.  Many of the decisions at all levels are based on short to intermediate term political or geopolitical consideration and often "bite" the hands of those contributing to economic advancement, such as foreign business owners stung by intellectual property theft or outright theft.  With so much economic and political power concentrated in so few hands, it's easy to see how problems such as conflicts of interest, corruption, and misallocation of resources have arisen to disruptive levels over time, especially at the local level.  At present, there's very little opportunity to express grievances via official political channels.  In fact, dissent is discouraged and in many instances extinguished.  The structure of the legal system is far less transparent than observed in the US.  Property rights are still a major work in progress as evidenced by the fact that many citizens have witnessed property apprehended with minimal compensation by local and national authorities.  As mentioned, state owned enterprises dominate the political and economic landscape and help politicians perpetuate the top-heavy, relatively inefficient political and economic decision-making process.  

Talk of rebalancing the economy is the primary focus now in China.  It's sorely needed.  The current investment and export led model is hitting its natural boundaries.  Rebalancing and broadening the economy is required if China wants to advance to the next level.  But, considering the rigidity of the structures in the country and the fact that so many of the incentives for rebalancing are currently misaligned (badly), it's very difficult to see how the country will be able to manage an orderly transition from a model heavily dependent on state directed investment to a model more dependent on consumer spending, a system that in many respects requires more diffuse, entrepreneurial, dynamic decision making at all levels.  It's fair to wonder aloud whether China's state owned enterprises, heavily concentrated in the investment and export sectors are willing to cede control, whether the local, regional, and national politicians that have worked hand in hand with them (and profited from them) are truly willing to change their decision-making in regards to these behemoths, and thus whether they're willing to accommodate greater levels of entrepreneurship and economic freedom, prerequisites for advancement from the middle income trap to higher income status.  Similarly, it's reasonable to ponder whether political leaders at all levels are truly willing to listen to voices concerned about issues such as pollution, food safety, public health, internal migration, rural/urban lifestyle and income disparities, and other issues that are bubbling rapidly to the surface and causing discontent.  Ultimately, we're skeptical that the one party system will prove dynamic or capable enough to flawlessly direct a much needed and complex economic transition on the one hand and accommodate a wide range of political voices on the other.  The historical record as it pertains to large, rigid one-party states managing major economic and political transitions isn't very kind.  If these issues aren't handled with a very deft touch, the country could easily face a significant and surprising downshift in economic activity, another major political upheaval among citizens along the lines of the Tiananmen Square demonstrations, and/or significant strife within the Communist Party and broader political system.  

Over its history, the US has been reasonably successful in accommodating new voices and assimilating new people and ideas into our economic and political culture.  No doubt, change has been resisted at many points, and the country has veered off course significantly at other points, but the adaptable and accountable system, not to mention the built-in structures encouraging entrepreneurial activity, have allowed us to fend off the challenges and challengers over time that we've worried about in spells.  Adaptable and accountable structures gave the political and economic system here breathing space and margin for error during important times of transition or upheaval allowing the US to achieve global economic primacy.  China, which to this point seemed to many pundits unstoppable in its quest to take (or at least share) global leadership from (with) the United States is all of a sudden facing its own very important transition.  The lack of adaptability and the lack of ability for political leaders at all levels to truly tolerate other voices and even dissent without pushback, not to mention the fact that the economy requires massive rebalancing that stands against a heavily entrenched incentive structure within China's political and economic systems, leads us to believe that China will have a very difficult time in the near to intermediate term achieving the levels of innovation, entrepreneurial activity, and political dynamism required to escape the dreaded middle-income trap.  China has mostly picked the low hanging fruit when it comes to economic advancement.  Movement to higher levels in the global economic hierarchy will require drastically different tools.

Global Valuation Update

We last looked at the long-term valuation picture back in May for various countries and indices around the world.  Normally, we’d wait a few more months for an update.  But, in light of the fact that various global markets have experienced some severe turbulence over the past few months, especially emerging markets, we thought it would be appropriate to check back in on various valuation metrics.  

As with the last update, we’ll focus on three metrics, 10-year normalized P/E, price to book, and trailing 12-month index EV/EBITDA, across 17 individual developed and developing country indices and broader regional indices.  To ascertain a rough overall valuation ranking, we’ll average the rankings across all three individual valuation metrics, then rank the 17 indices based upon the average value.  We’ve derived all data for the calculations from Bloomberg’s index earnings data.

Let’s begin with long-term normalized P/E ratios, ranking the indices from most expensive to least expensive:

Source: IronHorse Capital

Much like mid-May, Japan and India top other developed and developing countries when it comes to price relative to long-term average earnings.  With the recent strong move in US markets, the US overtook Germany for the third spot.  Greece, Russia, and Spain maintain the three lowest valuation positions, with Italy and France not too far behind.  The Euro periphery, which France is increasingly becoming associated with, remains the cheapest corner of the global equities space on a long-term P/E basis.  Overall, relative P/E rankings remained relatively static over the past few months.  PE ratios in absolute terms shifted down, especially in emerging market economies which have been hit hard over the past few months.  The MSCI Emerging Market Index ratio has fallen, for instance, over a point and a half.  Regionally, ex-US, Asian countries display a P/E ratio approximately 25% higher than the ratio for European stocks and approximately 40% higher than the general emerging markets PE ratio.  The S&P 500, however, remains more highly valued than the other regional/international indices.  

Source: IronHorse Capital

On a price-to-book basis, Euro periphery and emerging market indices still occupy many of the lower spots.  There are a few notable differences, however.  Japan looks much more attractive on a price-to-book basis than using normalized earnings, potentially due to the fact that using normalized P/E ratios in Japan could be problematic due to their long-standing deflationary conditions and stagnant economy.  The US and India remain at the top of the valuation list.  EAFE stocks hold a higher valuation than emerging stocks, just as above, but Asian stocks come in at lower valuation levels than European stocks flipping the situation in the P/E category.  Japan probably helps pull the overall Asian index downward.  

Source: IronHorse Capital

On an EV/EBITDA basis, trailing 12-months, Japan finds its way back near the top of the table, with the US and India again occupying spots near the top.  Brazil shoots to the top of the list, a sharp contrast to its lower relative valuation placements in the other tables.  Again, Asian equities hold a higher valuation placement level than Europe, while developed market valuation again exceeds emerging market valuation.  German equities look better by this metric.  Still, the Euro periphery again occupies most of the final spots.  

Source: IronHorse Capital

Take all valuation metrics into account and there are a few relative valuation ranking changes from our last report in May.  First, the fact that Japanese stocks cooled off a bit this summer pushed the relative ranking down two spots.  Likewise, China’s equity market declines have pushed the Shanghai Composite’s relative ranking down four spots.  As such, all the BRIC indices except for India reside in the mid to lower portions of the table.  

The broader picture is reasonably consistent with the picture a few months ago.  India and the US remain overvalued relative to peer countries, while the European periphery hangs near the bottom.  Meanwhile, emerging market valuations keep creeping downward.  

As we mention every time we look at longer-term valuation metrics, these numbers shouldn’t be used for short or intermediate term trading decisions.  However, the longer term valuation metrics demonstrate decent statistical significance when it comes to forecasting long-term annualized returns (i.e. 8 to 12 years out).  Based on the above valuation information, markets are obviously discounting or over-discounting the prospect for poor outcomes in the periphery European nations and emerging markets (ex-India), generally a precursor to decent/positive outcomes in the long-term.  As such, we believe that long-term returns in these areas will outpace returns in areas such as the US, India, and Australia over the next decade on an annualized basis, though the volatile news flow emerging from these countries should continue to keep investors holding onto their seats in the near term.