Will the rally in cheap markets continue?

 

Globally, stock indices are on the up again after a slight jitter in June. We are questioning how synchronised this move is, monitoring the effects of our regional equity allocations daily. As you might recall from our article on valuations released in April long term valuation differences, the main driver behind our relative overweight of emerging markets versus US stocks, were very high at the end of March.

Early signs that neglected cheap markets are attracting investors’ attention
Today we look at our main regional split, comparing cumulative returns in USD between Global stocks as well as US, International and EM equity over the last 2 months.

 

Source: Morningstar, July 6th 2020

 

International equity (yellow) has been outperforming US stocks (grey) since early June but has given back some of that outperformance more recently. However, EM equities (orange) have been on a run since mid-June, widening the performance gap over US equities.

Valuation gaps remain

At MASECO, we watch CAPE – a market valuation measure that uses real earnings per share over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle. Changes in cyclically adjusted price earnings (CAPE) ratios are driven largely by price changes and to a lesser extent by changes to 10-year average earnings. US, International and EM regions all have a higher CAPE, as at the end of June, versus three months ago. However, valuation differences are still very large (US high, EM and International low) which is important when one considers the source of future expected returns.

 

Source: Research Affiliates, June 30th 2020

 

The CAPE of Emerging Markets equities is still at the 10th percentile compared to its own valuation history. In other words, 90% of all historic CAPE values have been higher than the current CAPE of 13.3x. US equities are still at the other end of the spectrum, its current CAPE of 29.9x is in the 95th percentile, meaning US equities have rarely been as expensive as they are today.

Therefore, from a long-term valuation perspective, our case is still intact for EM to outperform US stocks in the coming months or years.


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