On a recent visit to my dentist's clinic, this honorable man, entrusted with keeping thousands of teeth in New York City in good repair, asked me if I had discovered any new countries to invest in. Not stocks, not mutual funds, not even hedge funds, countries!
Over the years, this highly successful Doctor Tooth has invested in scores of companies and funds and has achieved better than respectable returns. In general, he has tended to invest in stocks of companies that he understood well in the dental or health care areas, or occasionally in the consumer technology sector. For example, he has done very well with Nobel Biocare (NBCHF.PK) and Stryker (NYSE:SYK) and Apple (NASDAQ:AAPL). In fact, when I think of it, he seems to have done better than most professional money managers that I know.
In the past two to three years, my dentist has been more daring and has ventured further afield from his comfort zone. He has been investing in emerging markets, a brilliant decision on his part considering the huge gains recorded overseas in every year since 2003. The weakness of the US dollar against emerging market currencies has further turbocharged the US investor's returns in dollar terms.
As a committed contrarian, I steeled myself against advising him to invest in, say Vietnam or Slovenia, or any other fashionable new frontier du jour. Once he pulled the tools out of my mouth and I could speak, I said half in jest half seriously: "yes, the US" to which he chuckled, or scoffed, as if he was now the serious investor and I was some amateur jokester. Then he motioned slowly towards the drill, with perhaps punishment on his mind.
No Longer Flat
The brilliant New York Times columnist Tom Friedman wrote a book 'The World is Flat: A Brief History of the Twenty-first Century' in 2005. That is old news in the world of investing. The outstanding performance of emerging market stock indices in places like Brazil, Russia, India, China (aka the BRIC countries) and many others has closed the valuation gap with developed markets indices.
More than that, emerging markets are in fact now more highly valued than developed markets in the US, Europe and Asia. It means that the US market went from a premium to emerging markets a few years ago to a discount now. The world has gone upside down.
Consider for example the Price to Earnings (NYSE:PE) ratios of these markets (on estimated 2007 earnings):
United States S&P 500: 15.5x
United Kingdom FTSE 100: 12.1x
France CAC 40: 12.4x
Germany DAX 30: 12.6x
China Shanghai: 42.7x
India Sensex: 22.4x
The usual justification for higher PE ratios in emerging markets is that they are growing faster. This may be the case today but these countries are also more dependent on cyclical industries such as metals, mining and energy, which are now in a strong boom. Cyclical industries trade at low multiples in boom periods. But not in this case apparently.
Emerging markets also suffer from greater political risk. Pakistan's estimated PE of 18.6x compared to the UK's 12.1x is positively nonsensical and incorporates a degree of complacency among investors that 'everything will work itself out'.
So was my quip to buy the US now a good call? The crisis in financial services is likely to linger through the first two quarters of 2008 so there is no reason to rush into US stocks today. But one of two things will happen from here. Either the world economy will recover its footing and the US and Europe will look like the cheapest markets, or the economy will turn down and emerging market stocks and their cyclical industries will suddenly look extremely extended.
In either scenario, emerging markets today look like an increasingly poor bet. It is difficult to call precisely the top of a bubble and being too early by a year means missing as much as 30 or 50% but when the sentiment turns, some of these markets will fall 50% or more.