Friday, May 12, 2006

It's different this time ...

It's different this time ... that's always the siren call when a market of any sort has gained on, and on, for longer than anyone thought possible.

It was heard at the NASDAQ peak in 2000, and I'm sure in the tulip bulb mania too. While it is a sensible thing to consider - and to remember that more often that not it is a siren song - it isn't always. And I think that the emerging markets phenomenon is one of those cases, where there's a fundamental shift going on, possibly a change or modification to the old world order.

I've made the point several times on this blog that I think the US market in particular appears extended and certainly leading indicators have suggested that the excess liquidity flowing around the world have led to global asset inflation.

A finger is often pointed at the emerging markets, saying that this is a particularly risky market, and it has experienced outsized gains over the past three years, placing its stock valuations on par - in many key ratios - with US markets. This, some pundits say, is clear evidence that the overall market is overvalued and that emerging markets in particular are poised to tumble, when sense returns to the market.

Overall, I agree that many markets are high: I just don't agree that the emerging markets are the clear sign of this. Stock markets are like a reputation: it takes a long time to get one, but once it's in place, many people stop thinking about the market, and consider only its reputation. They start only seeing what was once there. I think this currently provides a benefit to the US markets, and a disservice to many emerging markets.

Many emerging markets have, over the past decade, opened their economies, freed their currencies, and placed their public finances on sound footing. Their companies are more robust than ever before, with modern management (trained in the US in many cases), and robust internal key ratios - like return on capital and equity, earnings growth and cash-flow, and so on. They are, in many instances, true peers to some of the best global corporations - or very close to it.

In the US, on the other hand, there is a very fundamentally deteriorating situation in my view, which isn't properly being valued in the markets:
Frankly, when I consider all the variables - I see the house above as more emblematic of the current US situation, that I seeing it as an emerging market.

Many people however are conditioned by years when that was clearly an emerging market house, and still see it that way. Me, I'm noticing how nicely some of the other neighborhoods have been fixed up - so to speak - and this one, seems to be running down.

Just an observation - and it's a reason why I'd rather pay roughly equivalent multiples for emerging markets with their significantly faster growth, compared to US markets. Sometimes, some things are different - it just takes awhile for folks to notice it.


The Confused Capitalist


Trent said...

Your four points against the US market both contradict your thesis and reveal apparent biases in your thought process.

1) Years of underfunding public schools/colleges to provide short-term tax relief.
1-a) State and local taxes pay for 80 per cent of US education spending.
1-b) Years of underfunding public schools versus five years worth of tax cuts doesn't jibe.
1-c) Why not criticize other government spending rather than tax cuts? They are an equal drain/competitor on education dollars. Defense, Social Security and Medicare all dwarf both education and the tax cuts.
2) Unfunded social security liability.
2-a) At least this one supports your (general) emerging markets thesis, where such benefits are not offered and workforces are much younger. But Japan and Western Europe are in far worse shape wrt benefits for retirees. Older workers, more generous benefits and fewer young people to support it all. If that is a case against the US economy, it is a case in spades against the other developed markets.
2-b) The granddaddy of emerging markets, China, is probably the worst prepared for an aging population. Its one-child policy and a cultural preference for male children have created what will soon become a population implosion. Improving economy will help people live longer, but there will be no young workers to support them.
3) Fiscal/Trade/Savings - simple math.
3-1) If emerging markets sell the US more than they buy from us we have to have trade deficits. If they return our money through excess saving rather than consumption we have to have low savings rates. The way the imbalances are resolved are if the US:
3-1-a) Quits buying more products from emerging markets than it sells to them. This would be bad for emerging markets.
3-1-b) Starts selling as much to emerging markets as it buys from them. This would be good for the US.
3-1-c) Defaults on its debt to foreigners. This would be bad for the emerging markets.
I am all for pointing out the risk factors in the US economy, as you have done. But if you are using that to make an argument for investing elsewhere you should make sure the arguments tie.

Canadian Capitalist said...

Jay: I beg to differ. I have a small position in emerging markets, specifically India, that I had initiated years ago. I would be really wary of emerging markets now.

Personally, I'd want a big discount on valuations in emerging markets because of all the risks involved: political risk (wars, instability etc.), currency risk, regulatory risk, liquidity risk, their extreme volatility (20% drops in a day), their small size compared to developed markets etc.

Another reason I am wary of them right now is mutual fund flows. Retail American investors have noticed that foreign markets are doing well and investing in them in record numbers. To me that is a fine contrary indicator.

Leonard Golub said...

MSCI emerging mkts index is trading at 14x earnings.

MSCI EAFE trades at 15x earnings

S&P 500 trades at 17x earnings

The discrepancy is therefore in risk factors to cash flow, and growth rates.

Speculation about all of this other stuff,as your post engages in, has little if anything to do with valuation as I see it.

L Golub
Solaris capital mgmt

Jay Walker said...

I certainly don't expect that everyone is going to see it the same way I do, and I freely acknowledge that many people take my position as in favor of heavy over-weighting for emerging markets.

I believe that there are many problems underlying the US economy - problems that heavyweight commentators like Warren Buffet has often pointed out.

I'm also heartened by the fact that one of the grandaddy's of emerging markets investing, Mark Mobius, still finds good value in many of them, particularly in comparison to many developed country markets. I guess I fall into the same camp as Mobius (good value in emerging markets) and Buffett (serious structural problems in the US).

I realize my position doesn't suit everyone, and I thank Trent and the Canadian Capitalist for their thoughts on this.

Jay Walker
The Confused Capitalist

Anonymous said...

To Canadian Capitalist I would also add the point that corporate governance/self interest is vastly different in Asian/LA regions.