Opinion: Incredibly cheap emerging-markets stocks still aren’t worth buying
By Howard Gold
Published: Feb 28, 2017 10:00 a.m. ET

Stay away because there are four big risks in China, Mexico and Brazil, among other countries

Whenever markets underperform for years, some people go bottom fishing. It’s part of a natural human impulse to find bargains by buying low, being greedy when others are fearful, etc.

Lately we’ve seen that with emerging markets (EM), which have underperformed for years and which I have written are in a secular bear market.

The largest EM exchange traded fund, Vanguard FTSE Emerging Markets ETF VWO, -0.64% has outperformed the S&P 500 Index SPX, -0.31% since last February’s lows by 34% to 29%.

But since the election, VWO has risen only about 3%, trailing the S&P’s 10%-plus gain. That makes me think the latest emerging markets pseudo-rally (one of several in this secular bear market) is running out of steam.

Yet pundits and commentators are once again recommending emerging markets. According to Research Affiliates, emerging markets trade at a Shiller cyclically adjusted P/E, or CAPE, of only 12 times the last 10 years of earnings, adjusted for inflation. U.S. large-cap stocks have an elevated Shiller P/E of 28. (Lately, the Shiller P/E has been too pessimistic about future U.S. stock returns.)

Yes, valuations of emerging markets look attractive. But though I’d like to buy again at some point, right now I’m staying away for four reasons.

1. EM earnings growth ain’t that great. Morningstar estimates earnings for emerging markets companies will grow at 10% annually for the next five years. The S&P 500, it projects, will grow 9% a year during that time. That’s not a big premium for markets that are roughly 50% more volatile.

Meanwhile, the International Monetary Fund has revised its GDP growth estimates down for major EM economies like Mexico, India and Brazil. The World Bank expects EM GDP growth to accelerate to 4.2% annually, from 3.4% in 2016, but worries that investment in these countries is at a multiyear low, which “can have insidious and corrosive results.”

Also, research by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School, among the world’s leading authorities on global equity returns, found little correlation between GDP growth and stock market returns. So, it’s a fallacy to buy EM stocks “because their economies are growing faster.”

2. The U.S. dollar should remain strong. If the Federal Reserve hikes the federal funds rate at least three times this year while other central banks stand pat or cut rates, how can the dollar not strengthen? And if President Donald Trump carries out the policy miracles his ardent followers expect (shredding regulations, cutting business and personal taxes, passing a big infrastructure package), inflation will pick up and the Fed would raise rates even faster, boosting the dollar more.

A stronger dollar is bad for oil and other commodities in which emerging markets specialize (Russia, Brazil and Mexico, for example). Greater dollar strength would likely clobber Latin America, which depends heavily on commodity exports and whose MSCI EM Latin America index surged 31.5% in 2016. Russia’s RTS index soared by more than 50% in dollar terms last year; it’s off 0.5% so far this year. These stocks have come a long way in a short time and are ripe for correction; greater strength in the dollar would do the trick.

3. Trade wars would hurt emerging markets most. Wall Street isBETTING heavily on the “good” Trump prevailing, he of the tax cuts and fiscal stimulus. But what happens when the “bad” Trump shows up? Border walls, mass deportations, and punitive tariffs play well in the heartland, where his supporters actually think he’ll bring back the well-paying manufacturing jobs of the 1950s.

But stiff tariffs and trade wars would hit emerging markets particularly hard, especially China and Mexico, the top two exporters to the U.S. We might tip into recession, too, but there’d be absolute carnage in emerging market economies and markets.

4. China’s economy is shaky. China may be the world’s second-largest economy, and it’s the biggest emerging market, so what happens there profoundly affects emerging market economies and stocks.

But China, which posted 10% annual GDP increases in the mid-2000s, could see growth drop to the IMF’s projected 6.5% this year and 6% in 2018. Meanwhile, the country’s debt load is enormous, and its real estate may be in “the biggest bubble in history.”

As 2015’s stock market melt-up and crash showed clearly, China is a rigged market utterly lacking in transparency and manipulated by the government. No investor should trust it. And yet leading providers are considering boosting China’s weighting in the big EM indexes, which means that more than ever, buying emerging-markets ETFs means buying China.

I’ll wait for the indexers to come to their senses. Until then, which may be a while, investing in broad global index ETFs that already have nearly 20% of their assets in emerging markets or in U.S. multinationals that get lots of revenue from emerging markets will be good enough for me.

Howard R. Gold is a MarketWatch columnist and founder and editor of GoldenEgg Investing, which offers exclusive market commentary and simple, low-cost, low-risk retirement investing plans. Follow him on Twitter @howardrgold.