Emerging market stocks have struggled quite a bit recently. Down 15% last year and significantly underperforming U.S. stocks since mid-year 2012, some investors are wondering: Is it time to abandon Emerging market stocks?

The quick answer is no. And here’s why.

Allocating to emerging markets means investing in stocks of companies based in developing countries around the world.  Over its history, emerging markets (EM) have been quite cyclical with long stretches where it outperforms U.S. stocks but also stretches where it underperforms. While frustrating to investors in EM stocks, what is happening right now is not unusual. In fact, because this cyclical nature (strong returns over different time periods) U.S. and EM stocks complement each other quite well.

Although I went into the weeds a bit and on a few tangents with this research (the product of which somehow resulted an 18-tab spreadsheet) here’s a brief overview of the key takeaways:

• From 1989 to 2015 Emerging Markets returned 9.6% annualized versus 9.8% for the S&P 500 index.
• While the compounded returns are similar, U.S.-stocks and EM-stocks have performed very differently over different time periods, making them good diversifiers for each other.
• Periods of weakness in the commodity markets (like right now) are typically bad for Emerging markets stocks.
• Emerging markets tend to underperform U.S. stocks during periods of U.S. dollar strength (like right now).
• Emerging markets are cheap compared to much of the developed world. This favors the deliberate, long-term investor in EM stocks.

The remainder of this post will expand on these points, and I think you’ll agree that this isn’t the time to abandon emerging market stocks.

Similar Performance But In Different Time Periods

As mentioned previously, since January of 1989 the S&P 500 index has compounded at an annualized growth rate of 9.8% and Emerging Markets at 9.6%. Pretty similar performance. 

But, over the last two-plus decades, this comparable performance has come at different times. As a result, a portfolio equally weighted to both would have grown at 10.1%. They tend to complement each other quite well with differing cycles of strong performance.  The following graph illustrates this well. 

In the early 90’s Emerging Markets outperformed U.S. equities. Then during the tech boom in the late 90’s U.S. stocks drastically outperformed EM. Following the tech bubble, emerging markets again ruled the day, only to falter again recently.

But again, an allocation to both during this period would have increased one’s annualized returns and smoothed out the returns quite a bit.

When Emerging Market Stocks Struggle

Most commentary tends to suggest two things are at least partially responsible for poor emerging market performance:

• a drop in commodity prices as emerging market countries tend to be both producers and exporters of commodities,
• and a rising U.S. dollar which reduces foreign stocks’ returns to U.S.-based investors. For example, if EM stocks are up 10% in local currency terms, but the U.S. dollar rises 6% versus EM currencies, the net return to U.S.-based investors, after currency adjustments, is only 4%.

The table below outlines how these factors interact with U.S. and EM stocks over four distinct time periods and show that, as often suggested, weak commodities and a strong U.S. dollar have historically hurt EM investors. 

While the first period (Jan ’90 – Jun ’95) saw strong returns for both markets, EM stocks outperformed nicely. This despite little commodity price increases and a rising U.S. dollar.

However, over the next three periods, the relationship holds more firmly. From ’95-’00 US stocks outperformed (weak commodities and a strong U.S. dollar), from ’00-’07 EM stocks outperformed (strong commodities and a weak U.S. dollar), and most recently U.S. stocks have ruled again (falling commodity prices and a strong dollar).

Emerging Stocks are ‘Exceptionally Cheap’

According to Christopher Brightman, the CIO of Research Affiliates, the Shiller P/E ratio on Emerging-market stocks fell to 10 in January. “There have been only six times when the measure has dipped below 10 over the past 25 years. In the following five years, the stocks rallied an average 188 percent.”

Brighton continues “The exodus from emerging markets is a wonderful opportunity — and quite possibly the trade of a decade — for the long-term investor.”

Additionally, in a recent column Larry Swedroe, the Director of Research for Buckingham Asset Management, writes that U.S. valuations are “now much higher than emerging market valuations.”  Swedroe, looking at four different valuation metrics (Price/Earnings, Price/Cash Flow, Price/Book Value, and Price to Sales) finds that U.S. valuations are 83% higher than emerging market valuations across these metrics, with the closest gap, a still wide 46% for the Price/Earnings ratio.

He, therefore, advises the following:

“There will almost certainly be periods when U.S. stocks underperform. There will just as certainly be periods when they outperform. The key to being a successful investor isn’t, as Wall Street and much of the financial media would like you to believe, about being able to accurately forecast which asset will do well when. 

Instead, it’s about remaining disciplined and adhering to your asset allocation plan. That means having the courage to rebalance to your target allocations, buying what has done poorly and selling what has done well—and that’s something a lot of investors are unable to do on their own.” 

A Summary

To wrap up: over its history emerging markets have provided similar returns to those of U.S.-stocks, but these returns tend to come at different times. As such, they provide diversification to a U.S.-based portfolio. Additionally, EM stocks have struggled during periods of commodity weakness and U.S. dollar strength, both of which are happening right now.

But the good news is that emerging market stocks are cheap, ‘exceptionally cheap’ according to some. The economy goes through cycles and so does investing. Just like you shouldn’t expect commodity prices to fall forever and the U.S. dollar to continue to climb indefinitely; you shouldn’t expect emerging markets stocks to underperform forever.

U.S. stocks have been one of the best places to invest over the last five years; if the cyclical nature of the US/EM relationship teaches us anything, this doesn’t mean it will be the best place over the next five.

For those wondering how an Emerging Market fund (or any other fund) fits into your Intel Retirement account strategy, join our investing workshop coming up at the end of March. 

For those curious MSCI lists the following twenty-one countries as part of its Emerging Markets index: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

Performance data for the MSCI Emerging Market index begins in January 1989.

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