The 1 Market Investors Are Overlooking

U.S. stocks are lower this morning, with the S&P 500 (SNPINDEX: ^GSPC  ) and the narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) down 0.19% and 0.16%, respectively, at 10:05 a.m. EDT.

Emerging markets
In fact, investors are abandoning or overlooking more than just a single market – it's an entire asset class: Emerging market equities. The effect is clear; the following graph shows the stark divergence in performance, on a total return basis, between the U.S. stock market and emerging markets:

EEM Total Return Price Chart

EEM Total Return Price data by YCharts

Emerging markets are lagging by some 30 percentage points over a period of little more than half a year! Lest you think this is simply a correction following a period of wild outperformance by emerging markets, take a look at the following, which highlights the relative performance of both indexes from the bear market bottom of March 9, 2009:

EEM Total Return Price Chart

EEM Total Return Price data by YCharts

The argument for emerging markets is not the familiar "GDP growth is higher" chestnut – which, in any event, is fallacious -- instead, it's based on a much more robust line of reasoning: they're simply cheaper than the U.S. market.

Last October, asset allocation expert Mebane Faber put the cyclically adjusted price-to-earnings (CAPE) ratio of the MSCI Emerging Markets Index ETF (NYSEMKT: EEM  ) at 15.3, against 21.6 for the S&P 500. Since then, the gap in valuations has widened, as the S&P 500's CAPE has risen to nearly 24. While I don't have an updated figure for the Emerging Markets ETF, the underlying index has fallen 3.7% in dollar terms over that period (even in local currency terms, it's flat), so it's a safe bet its CAPE is lower today than it was then. (The CAPE is based on average real earnings over a trailing 10-year period, which, on average, increases over time in a very stable manner.)

That valuation gap will almost certainly manifest itself in the years to come with a performance gap -- in favor of emerging markets, this time. On Tuesday, another asset allocation specialist, fund manager GMO, will give its seven-year asset class return forecasts as of the end of June. Those forecasts have emerging market equities generating an annualized return of 7% after inflation against negative 1.2% for large-capitalization U.S. equities. That's a massive difference, but it's consistent with the difference in valuations

Personally, I recently added the iShares MSCI Turkey Investable Market Index Fund to my model portfolio, after recent concern over political stability knocked the Turkish market down. I think patient, value-oriented investors might consider doing the same in their real-money portfolios.

Alternatively, if you're looking for the "best of both worlds," a recent Motley Fool report, "3 Strong Buys for a Global Economic Recovery," outlines three companies that could take off when the global economy gains steam. Click here to read the full report!


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