Two levers move stock market returns: earnings and the multiple investors pay for them.1 Corporate earnings are a powerfully mean-reverting time series.2 Real earnings per share (EPS) data show that profits in the United States are approximately 50% above their long-term trend. In sharp contrast, emerging market profits are 10% below trend.3 The very nature of globalization means profit margins across regions become more comparable, not less. From current levels, it is reasonable to anticipate that emerging market companies can surprise U.S. companies in profitability changes. It’s not the precise historical average or prospective estimate that matters, but the wide spread in expectations.
Although subject to investor sentiment and behavior, the other lever—valuations—is also favorably positioned. Emerging markets look inexpensive by any valuation metric. We prefer the cyclically adjusted price-to-earnings ratio (CAPE) measure, also known as the Shiller PE, because it smooths the business cycle. The U.S. stock market is perched at a 25x CAPE, while emerging market stocks are nearly half that level at 14x. In fact, fundamentally weighted emerging markets portfolios trade near book value, levels touched in the depths of the Global Financial Crisis in February 2009. From February 28, 2009, to December 31, 2010, a fundamentally weighted emerging markets index rose almost 150% and outperformed the broad emerging markets by approximately 9%.4
What is more likely to have a positive surprise: a market with high valuations, above trend profits, and high expectations, or a market with dirt cheap valuations, below average profits that can revert to the mean, and overwhelmingly negative sentiment? Emerging market stocks may be poised for meaningful appreciation.