U.S. stocks aren't the bargain they were a year or two ago. After rising 17% in the year's first seven months, the S&P 500 is currently trading at 19.5 times trailing 12-month earnings. That's the most expensive valuation for the index since January 2010. Many U.S. stocks are at record highs, making it difficult to find stocks that are deeply undervalued. To find true value investments, the best place to look may be outside our borders.
Emerging markets have been falling even as U.S. stocks rise. The MSCI Emerging Markets Index (NYSEARCA:EEM) is down 12% this year, underperforming U.S. stocks by nearly 30%. The performance among emerging markets has been so bad, in fact, that Goldman Sachs stopped recommending stocks with heavy BRIC exposure. That's a big change for a firm that's been trumpeting emerging-market growth for years and even coined the term "BRIC."
After a period of tremendous growth following the global recession, emerging markets have been essentially beaten down for two straight years. As a contrarian investor, I don't see that as a bad thing. I like to invest in strong growth areas when they've been knocked down a peg or two. And right now, emerging markets are extremely cheap when compared to U.S. stocks. Collectively, emerging markets are trading at roughly 10 times 2013 profit estimates. When you consider the growth outlook for most emerging markets remains stronger than the U.S., they appear to be attractively valued.
In the next five years emerging markets will grow 6% annually, according to the International Monetary Fund. Meanwhile, the Federal Reserve projects the U.S. economy to grow between 2.3% and 2.6% this year and between 3% and 3.5% next year. That means that the average emerging market stock is not only half as cheap as the average U.S. stock on a price-to-earnings basis, but is also tied to an economy that has double the growth prospects.
A large part of the growth opportunity is due to population expansion. India's population alone is expected to grow by 450 billion people by 2050. Emerging nations already make up 80% of the world's population, but account for just 40% of global GDP. As those populations expand, so too will their footprint on the global economy.
It's hard to invest in something that has been so beaten down. Finding a bottom is never easy. In the case of emerging markets, however, the turnaround has already begun. Since dipping to an 18-month low in late June, the MSCI Emerging Markets index has risen 7.5%. The FXI and the EWZ, ETFs that track the performance of stocks in China and Brazil, respectively, have each advanced more than 5% during that time. Slowly but surely, the cloud over emerging markets appears to be lifting.
I believe the recent rebound in emerging markets is just the beginning of a long-term rally. Furthermore, the investment risk is already reduced due to the deep discount of emerging market valuations compared to U.S. stocks. That's why I'll be adding more exposure to emerging-markets in my portfolio.
With U.S. markets establishing all-time highs on almost a weekly basis, there are very few true value plays out there. To find them, you have to look overseas. What you'll find in emerging markets is a growth sector that has suddenly become grossly undervalued.