Emerging Markets: So Unpopular It's Time to Buy?

As if this needs pointing out, emerging market stocks have sucked wind in 2013. Despite rallying more than 15% since its June low, the iShares MSCI Emerging Markets ETF (EEM) was still in negative territory in late October, while the Vanguard S&P 500 ETF (VOO) is up more than 20% year to date.

But an interesting note from the wonks at Research Affiliates makes a pretty compelling case for emerging markets going forward. Now to be clear, Research Affiliates loves them a contrarian play. “One of our favorite disciplines is to look at the most feared and loathed areas of the markets,” managing director John West wrote in the note, as a way of setting up a discussion of emerging market stocks.

The crux of the argument centers on the S&P 500 Cyclically Adjusted PE ratio, known as the Shiller PE ratio, and referred to as PE 10 at YCharts. Currently it's well above its long-term average of 16.

S&P 500 Cyclically Adjusted Price-Earnings Ratio data by YCharts

Head over to emerging markets, and the Shiller 10-year inflation adjusted PE ratio is below 14. That's a whole lot cheaper than U.S. stocks. As West explained: “ . . . over longer stretches of time, cheap valuations typically act as a tailwind while lofty PE ratios act as a headwind. And when valuations are at particularly wide spreads, these winds can be gale force!

Research Affiliates crunched the numbers and found that when the U.S. Shiller PE is in the range of 20-25, the median forward five-year annualized gain for the S&P 500 is 4.2%. When the emerging market Shiller PE is in the 10-15 range, the forward annualized five-year gain is 13.6%.

Now there's one big caveat: the US number is based on data going back to 1927. The emerging markets to 2005. Not exactly the sort of data depth you'd want to see. West tackles that head on:

“Admittedly, we have a far shorter historical record [for EM] with far fewer observations supporting such sizable forward returns. But, if a limited history is any indication, almost a full 1,000 bps compounded per annum for five years is a heckuva premium. Even if we extrapolate the U.S. experience at these valuations, there's a 500 bp annualized premium (9.3% less 4.2%) for being an equity investor at valuations of 10–15X versus 20–25X earnings.” [note: the 9.3% West refers to is the 5-year forward annualized earnings for the S&P 500 when the Shiller PE is in the 10-15 band, which is where emerging markets are today.]

The $45 billion iShares MSCI Emerging Markets is the big gorilla in the emerging market space, but it has been outpaced by its derivative offering: the $2.9 billion iShares MSCI Minimum Volatility ETF (EEMV):

EEM Total Return Price data by YCharts

That said, it is important to note that the higher yielding defensive sector stocks that you'd expect to find in a low volatility portfolio are a whole lot more expensive. (That's one way the U.S. and EM are similar.) According to Morningstar, the iShares MSCI Emerging Markets Low Vol portfolio has a forward PE ratio of nearly 15. The iShares MSCI Emerging Markets portfolio's forward PE is 11. The top three holdings in the “regular” emerging market's ETF are Samsung Electronics (SSNLF), Taiwan Semiconductor (TSM) and China Mobile (CHL).

If you're still thinking low vol is how you'd like to experience emerging markets, you might want to take a look at the $5.3 billion WisdomTree Emerging Markets Equity Income ETF (DEM). This dividend-weighted portfolio (rather than the typical market cap weighted approach) has a current yield of 4%. While not strictly low volatility, focusing on companies with the wherewithal to pay dividends tends to skew you to the less racy names. And that current 4% yield is indeed a nice income cushion when prices are roiling. According to Morningstar, WisdomTree Emerging Markets Equity Income has a forward PE ratio of less than 10.

Right now the trick with emerging markets is to avoid commodity-related stocks given global demand weakness. What's got a more bullish outlook is the notion that rising incomes in emerging markets are pushing demand for consumer-related stocks. The EGShares Emerging Markets Consumer ETF (ECON), which tracks the Dow Jones Emerging Markets Consumer Titans 30 index, has been around since September 2011. The ETF has gained more than 30% since then; during the same stretch the iShares MSCI Emerging Markets ETF is flat.

WisdomTree recently joined the consumer-sector space with the WisdomTree Emerging Markets Consumer Growth ETF (EMCG).

Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at editor@ycharts.com. Read the RIABiz profile of YCharts. You can also request a demonstration of YCharts Platinum.