Image Credit: Christophe Vorlet
By Jason Zweig | May 27, 2016 11:14 am ET
As investors search for bargains in a world of overpriced assets, they should be guided by the EMH.
That isn’t the Efficient Market Hypothesis, which holds that the price of a security reflects all available information. It’s my own Emetic Market Hypothesis, which says if the mere thought of owning an asset turns your stomach, that’s probably a sign you should buy it.
After years of strong returns, U.S. stocks are back near their all-time highs, and bond yields aren’t far above their record lows. The rosy recent past makes investing in U.S. stocks and bonds feel comfortable, though their high prices suggest future returns may be tepid.
European and emerging markets, on the other hand, have felt pretty nauseating. According to index provider MSCI, U.S. stocks have lost 1.4% over the past year, including dividends. But Europe is down 12%, and emerging markets have fallen a sickening 21.8%.
With Brazil near chaos, much of Europe only millimeters away from recession, a state-lubricated debt binge in China, a chance that Britain may withdraw from the European Union and negative interest rates in much of the world outside the U.S., these markets are awash in bad news.
Investors have responded by pulling money out of Europe. From Jan. 1 through April 30, $7.5 billion flowed out of European stock funds, according to data from Morningstar, the investment-research firm.
Investors in emerging-market funds added a marginal $1.2 billion in the first four months of 2016, but over the past 12 months they pulled out a total of $24 billion.
Europe and emerging markets joined the U.S. this past week in rallying 2% to 3% as oil prices stabilized and investors became more comfortable with a possible interest-rate increase by the Federal Reserve next month. But stocks remain much cheaper overseas than in the U.S.
Consider price to book value, a measure of corporate net worth. Since 1970, according to data from MSCI, the average price to book value of European stocks has been about 25% below that of U.S. stocks. As of April 30, it is 40% lower. The dividend yield on European stocks, historically about one-third higher than in the U.S., is 69% higher.
In emerging markets, where MSCI’s data begin in 1995, the price to book is only half that of U.S. stocks, about a tenth below its historical average. Dividend yields are roughly one-third higher than in the U.S.
A lot could still go wrong in emerging markets, says Robert Arnott, chairman of Research Affiliates, a firm in Newport Beach, Calif., whose strategies are used to manage about $160 billion.
A short list: China’s debt bubble could burst, Russia might expropriate companies or start a war, lower commodity prices could crimp many economies, a rise in U.S. interest rates might send other currencies tumbling.
“But the reciprocal question is: What could go right?” says Mr. Arnott. “All it takes to create a bull market is for things to go a little better than expected.”
The lower prices in emerging markets offer margin for error while investors wait for positive surprises. Larry Swedroe, director of research at Buckingham Asset Management in St. Louis, points out that the average stock in Dimensional Fund Advisors’ Emerging Markets Value Portfolio, a $15 billion fund available only through financial advisors, trades at just 86% of book value. By contrast, U.S. stocks trade at nearly three times their book value.
In Europe, says David Herro, vice chairman at Harris Associates in Chicago and manager of the $26 billion Oakmark International Fund, a few leading banks offer “acute value.” Expenses are dropping, losses from nonperforming loans are declining and capital cushions are ample, he says, but the stocks “have just been crushed” over the past year.
For their low prices and high dividend yields, he likes BNP Paribas of France, Italy’s Intesa Sanpaolo and London-based Lloyds Banking Group.
Mr. Herro also thinks high-quality industrial exporters in Europe, including automaker Daimler, farm-machinery producer CNH Industrial and Swiss cement maker LafargeHolcim, will benefit from a stronger dollar and gradual economic recovery around the globe.
If you already own an international stock fund, check its website to see how much of its portfolio is in Europe and emerging markets. Not counting the U.S., European stocks make up about half the value of global markets and emerging markets roughly another 15%. Anything less, and you’re underexposed to undervalued assets.
Mind you, international stocks have underperformed the U.S. for what seems like forever; Japanese stocks are approaching three decades of disappointment. But research by Elroy Dimson, Paul Marsh and Mike Staunton of London Business School shows that low stock prices, not high growth rates, are the surest sign of high returns in the future. Just don’t expect overseas markets to outperform instantly.
Even professional managers whose job it is to invest in Europe and emerging markets put those markets somewhere between 6 and 8 on a nausea scale of 1 to 10. That isn’t as sickening as investing felt during the global financial crisis — but it’s probably just bad enough to lead to lucrative returns later.
Source: The Wall Street Journal