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MSCI Emerging Market Index is 50% overvalued

|Includes: iShares MSCI Emerging Markets ETF (EEM), VWO

David Hunkar wrote about the disadvantageous weighting of the MSCI Emerging Market Index. I would like to continue the blues by telling you that the index is seriously overvalued.

The likely return of MSCI Emerging Market Index during the next five years is 2.17% per year. The index offers a risk premium of 0.10% over 5 year T-Bond, which is ridiculous considering the risks involved in investing in the emerging markets.

The chart below shows the MCap/GDP multiple of each index component versus the average multiple of the last 10 years.


Source: The World Bank: Market capitalization of listed companies (% of GDP)

The weighted average MCap/GDP of the index is 50% above the long-term multiple. Indexes tend to revert to the mean, which is not good news for the returns of this one.

The investment return of an index is determined by dividends, business growth and valuation change:

Investment return = Dividend + Growth + Valuation Change

Factoring in the dividend of 1.7% and the 5 year weighted average GDP growth  of 8.3% results into 2.17% investment return.

The investment return depends heavily on how long it takes to revert to the mean. The table below shows some examples:

Dividend

Growth

Time

Return/Year

1,70 %

8,3 %

1

-23,60 %

1,70 %

8,3 %

3

-2,73 %

1,70 %

8,3 %

5

2,17 %

1,70 %

8,3 %

8

5,05 %

1,70 %

8,3 %

10

6,03 %

You might be earning a 6% return, if the mean reversion is slow. The bottom line is however: do you want to invest in an overvalued index?



Disclosure: I am long VWO.

Additional disclosure: I am planning to reduce my position based on the analysis.