No Need to Panic About Emerging Markets

No, it’s not 2008 for emerging markets — at least not in the way investors fear.

Harvard economist Carmen Reinhart stoked investors’ anxiety last week, saying that emerging markets are in worse shape now than during the 2008 financial crisis. Among Reinhart’s long list of concerns are a stronger dollar, mounting debt and various and sundry problems in Brazil, Chile, Argentina, Turkey, sub-Saharan Africa and the Middle East.

In response, Bloomberg News looked at a group of developing countries and found that they are, in fact, worse off now than during the financial crisis in some important ways. The group, for example, has a modest current-account deficit, whereas it boasted a big surplus in 2008. The countries’ economic growth is also lower than it was during the crisis, and their government debt-to-GDP ratio is higher.

It all sounds worrisome, but the relevance of Reinhart’s concerns to investors is questionable. For starters, most investors dabble in emerging markets through mutual funds and exchange-traded funds, and most of those investments are in stocks. There’s $588 billion invested in emerging-market stock funds and $92 billion in bond funds, according to Morningstar data.

Those stock funds have nominal exposure — or none at all — to the countries that Reinhart is concerned about. The biggest emerging-market stock fund is the Vanguard FTSE Emerging Markets ETF, with $66 billion in assets. Sixty percent of the fund is invested in China, Taiwan and India. Its combined exposure to South America, Turkey and the Middle East is just 13 percent, and 8 percent of that is in Brazil. (Disclosure: I own Vanguard funds and my asset-management firm buys them for investors.)

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High Times for Marijuana Stocks

Marijuana stocks would be the ultimate growth play if investors weren’t already so fired up.

It just got easier for U.S. investors to bet on pot’s big plans. Toronto-based Cronos Group Inc., which invests in medical marijuana producers, on Tuesday became the first marijuana company listed on a major U.S. exchange. Analysts expect its revenue to reach $34 million this year, up from $400,000 in 2016.

Cronos’s debut follows that of ETFMG Alternative Harvest ETF on Dec. 26, the first U.S.-listed marijuana exchange-traded fund. If ETFMG’s popularity is any indication, Cronos will soon be awash with money. Investors have already poured $386 million into the ETF through Tuesday.

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On Goldman’s Rosy Market Outlook

For anyone suffering whiplash after following the markets in recent months, Goldman Sachs’s well-known strategist, Abby Joseph Cohen, recently offered a soothing forecast: She pegged the S&P 500’s fair value at 2,100. As of this writing, the S&P 500 is trading at about 1,896.

Cohen didn’t show how she arrived at her valuation, but the calculation is straightforward: you use earnings per share multiplied by the fair value, price-to-earnings ratio. Et voila.

Problems arise and predictions vary, however, because neither EPS nor the fair value P/E is obvious — and the resulting fair value can vary wildly depending on the assumptions used for each of those measures.

To see the effect of EPS on fair value, let’s assume that the fair value P/E for the S&P 500 is 16.5. Looking at S&P’s earnings data, the forward operating EPS of $126 yields a fair value for the S&P 500 of 2,079. The forward, as reported EPS of $119 yields a fair value of 1,964. The trailing operating EPS of $106 yields a fair value of 1,749. The trailing as reported EPS of $95 yields a fair value of 1,568. (Operating EPS excludes non-recurring items; as reported EPS doesn’t exclude non-recurring items.)

By using the most conservative of those valuations, we’ve already shed 25 percent from Goldman’s estimate of fair value – a real life decline that would make investors weep – and we haven’t even normalized earnings yet.

If we then cyclically adjust earnings using a ten-year trailing average, the normalized operating EPS of $88 yields a fair value of 1,452. The normalized as reported EPS of $76 yields a –- gasp –- fair value of just 1,254.

The fair value P/E is as elusive as EPS. A common proxy for fair value P/E is the historical average P/E, and reliable U.S. stock data is compiled by Nobel laureate Robert Shiller going back to 1871. But which historical period should we use? From 1871 to 1945, the U.S. was effectively an emerging market. Soon thereafter, the U.S. joined an elite club of developed countries and eventually became the most creditworthy country in the world.

Investors appropriately priced the U.S. more richly in the “developed” period than in the “emerging” period. To see the effect of fair value P/E on the resulting fair value, let’s assume that EPS for the S&P 500 is $126. The average one-year trailing P/E since 1946 is 16.8, which yields a fair value for the S&P 500 of 2,117. But the average one-year trailing P/E since 1871 is 15.4, which yields a fair value of 1,940 – nearly a 10 percent haircut from the post-1946 figure.

One way around the problem of deciding which set of historical data to use is to build a fair value P/E from the bottom up (as I recently did for China) by using the sum of inflation, real productivity growth, and dividend yield.

The IMF estimates that U.S. inflation over the next five years will be 2.2 percent annually, and that real productivity growth will be 1.7 percent annually. The current dividend yield for the S&P 500 is 2.3 percent. The sum of these three variables is 6.2 percent, the inverse of which implies a fair value P/E of 16.1.

By these lights, Goldman’s fair value for the S&P 500 of 2,100 is aggressive. In order to get there, one has to assume the most optimistic earnings results for 2016 – a forward operating EPS of $126 – and a generous fair value P/E of 16.7.

Cohen may be right, of course, but investors would be wise to think critically about her assumptions. Cohen is no stranger to bullish calls. Near the peak of the tech bubble in late 1999, she believed that the market was near fair value. (Cohen says that in March 2000 she suggested that clients sell stocks.) In January 2008, Cohen predicted that the S&P 500 would close the year at 1,675. Spoiler alert: It didn’t.

My Bloomberg colleagues reported last week that the U.S. is showing worrisome signs of decline, including weakening retail sales, manufacturing, and wholesale prices. The S&P 500’s brutal selloff so far this year appears to echo those concerns, and 2,100 seems to be increasingly farther way, in my estimation.

So I’m inclined to use a more cautious valuation when looking at the S&P 500. I’ll take the normalized operating EPS of $88 and the fair value P/E of 16.1, and peg the index’s fair value at 1,417.

But investors need not accept Goldman’s or my estimation of fair value. Given how readily available good data is these days, every investor can form his or her own judgment about EPS, fair value P/E, and the resulting fair value for the S&P 500.

What’s your number?

Source: Bloomberg Gadfly, https://bloom.bg/2yX7uL7

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So About Those Big Corporate Profits

Jeremy Grantham, an astute investment strategist, recently raised doubts about American exceptionalism in such areas as health care and education. But as my Bloomberg News colleagues noted in an article about Grantham’s concerns, the U.S. has managed to maintain its exceptionalism in at least one category – making money.

Corporate America has been handsomely profitable since the financial crisis that erupted in 2008, outstripping the performance of overseas competitors. The earnings per share of U.S. companies, as represented by the S&P 500 Index, have grown by 105 percent since 2008. In the developed world outside the U.S., as represented by the MSCI EAFE Index, earnings per share have grown by 30 percent over the same period. In emerging markets, as represented by the MSCI Emerging Markets Index, earnings per share have grown by 8 percent over the same period.

Such success was hardly a forgone conclusion seven years ago. At the height of the financial crisis, the survival of many U.S. companies – to say nothing of their future profitability – was in doubt. By contrast, emerging markets were lauded for their growth and comparatively low levels of debt.

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Diverging Markets

Everyone has grown accustomed to thinking about emerging markets as a monolith — a collection of undifferentiated countries aspiring to the big leagues, with all of the heft and stability of more developed economies.

Emerging markets share similar traits, oftentimes the market prices them similarly, and so they all get wrapped into the familiar and popular one-size-fits-all basket called THE EMERGING MARKET FUND.

Today, that’s the wrong way to think about emerging markets.

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