Investors flee emerging markets at the wrong time

(MoneyWatch) As we have discussed many times, much of the "conventional wisdom" individuals hold about investing is wrong. Among the wrong, but strongly-held, beliefs is that there's a positive correlation between economic growth rates and stock returns. Believe that and you would assume that faster economic growth leads to higher stock returns. In fact,  research shows that there's a slightly negative correlation between economic growth and stock returns.

This belief that economic growth drives stock returns (it does drives per capita GDP) has lead investors making asset allocation decisions to become especially concerned about the prospects for emerging markets, where growth has slowed, in some cases dramatically, from its previous rapid pace. The fact that in the first three quarters of 2013 the MSCI Emerging Markets Index lost about 4 percent, while the S&P 500 gained about 18 percent, fueled concerns, leading some to liquidate their investments -- repeating the all-too-typical behavior of buying after periods of strong performance (at high valuations) and selling after periods of poor performance (at low valuations).

The problem for investors is that selling after periods of poor performance means that you are selling when valuations are low, and expected returns are high. They also fail to understand three important points. First, the lower growth expectations are already reflected in market prices. Second, valuations (such as P/E ratios) are a more important determinant of returns than economic growth. Third, since market prices already reflect the slower growth expectations, what matters to stock returns are surprises -- will growth be faster or slower than expected? And surprises are not only by definition unable to be forecasted, but happy ones are just as likely as unhappy ones. Consider this example: If China's growth is forecasted to fall from 10 percent to 6 percent, and growth actually comes in at 7 percent, all else being equal, stock prices should rise because, while growth fell, it was still faster than expected.

A recent study by Vanguard found that surprises in economic growth rates explain about 24 percent of the variation in stock returns -- and the correlation is statistically significant. On the other hand, the correlation for growth is actually -0.05, highlighting the fact that economic growth is unrelated to stock returns (the growth expectations are already built into prices).

Vanguard's study highlighted two examples. The first shows that for the 23-year period 1925-1947, real earnings per share of the S&P 500 companies was virtually zero. Yet, stocks produced a real return of 5 percent per year. On the other hand, for the six-year period 2007-2012, Chinese companies produced real earnings growth per share of almost 15 percent, yet real returns were -5.2 percent.

The bottom line for investors is that the price you pay (valuations) for expected growth is what drives investment returns. 

With that in mind, let's take a quick look at valuation metrics. Morningstar reports that as of July 31, 2013 the forward looking P/E of the stocks in its Emerging Markets Fund (VEIEX) was 11.7. Contrast that with the forward looking P/E of 15.4 for its 500 Index Fund (VFINX). That's more than 30 percent higher than the P/E of 11.7 of VEIEX. We see similar comparisons when we look at P/CF (4.6 for VEIEX versus 7.7 for VFINX, almost 70 percent higher) and P/B (1.5 for VEIEX versus 2.2 for VFINX, almost 50 percent higher). 

Ask yourself if you really want to be selling emerging market stocks when the valuations are suggesting that future returns (the only kind you can buy) are likely to be significantly higher than they are for U.S. stocks -- at least those in the S&P 500. Buying when expected returns are high is a much better strategy than buying when they are low.