Investors Leave Emerging Markets Behind

November 14, 2012 | Tom Salemy, CFA, CAIA, Partner

This week’s Chart of the Week highlights the relative underperformance of emerging market stocks compared to other “risky” asset classes. Since January 1, 2010, U.S. small-cap stocks¹ have returned a cumulative 35.8% and international small-cap stocks² have returned a cumulative 18% through October 2012. However, quite surprisingly, emerging market stocks³ are only up 8.9% over the same time-period.

Emerging market equities are still treated as a risk-on, risk-off investment. As the graph above illustrates, it appears that investors have returned to some of the riskier equity markets, but have left emerging markets behind. The underperformance of international small-cap and emerging market stocks compared to U.S. small-cap stocks is somewhat explained by investors’ continued concerns with Europe. However, when looking at one of the traditional valuation metrics, price-to-earnings (“P/E”) ratio, it appears that investors may be unfairly discounting emerging market stocks. As of 9/30/2012, U.S. small-cap, international small-cap, and emerging market stocks had P/E ratios of 33.7, 19.8, and 12.5, respectively.

Continued global economic and policy uncertainty suggests that this trend may persist. However, given their low P/E ratios, coupled with growth rates and fiscal health relative to developed countries, emerging market stocks should deliver long-term compelling returns, despite their recent struggles versus other risky equity indices.

¹Represented by the Russell 2000 Index
²Represented by the S&P Developed ex. U.S. Small-Cap Index
³Represented by the MSCI Emerging Markets Index