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Financial Industry Insights from Advisors Asset Management

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AAM Viewpoints – Emerging Markets Are Undervalued


 

It seems like the S&P 500 has been hitting a new all-time-high every week this year. Of course, it hasn’t, but it’s come pretty close. With that environment, we looked for other markets that aren’t as overvalued. We chose to focus in on Emerging Markets since they haven’t participated as much in the global recovery – mostly due to varied vaccination rates and regulatory risk. We found the relative valuations by looking at the spread between S&P 500 and MSCI Emerging Market index for various valuation metrics and we believe Emerging Markets are highly undervalued with the potential to be a great investing opportunity.

We gathered data going back to 1/31/1995 and put together daily price-to-earnings, price-to-sales, price-to-cashflow, and price-to-EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) and for both S&P 500 and MSCI Emerging Market indices. We then calculated the spread between to the indices’ valuation metrics. The spread determines which index is trading at a discount or premium relative to the other. Next, we needed to know the average spread, because there will always be some spread since we are comparing different baskets of securities. From there we found the difference between the current spread and the average. While we could just compare the two numbers, calculating z-scores (aka standard score) of the spreads allows us to compare all the valuation spreads, and conveys the magnitudes of the differences. All the data points are put onto a normal distribution curve with the mean at the center giving it a z-score of zero. Now we can look at the z-scores of the current valuation spreads and see how many standard deviations it is from the means. The further away the z-score is from zero, the less probability it will occur. So, if we believe in reversion to the mean, when we find valuation spreads on the tail-ends of the curve, then we have found an opportunity.

z-scores
Past performance is not indicative of future results.

valuation spreads
Past performance is not indicative of future results.

As you can see in the table above, the spread between S&P 500 and MSCI Emerging Market for various valuation metrics is huge. They haven’t been this wide since 1998 (which is shown in the charts below). The spread between some of the indices’ valuation metrics is two standard deviations from the mean. The spread shouldn’t get much wider than this. On a normal distribution, 95% of the data points fall within two standard deviations. The last time spreads were this wide (1/2/1998), the MSCI Emerging Market Index had an annualized total return of 14.3% over the next 10 years, while the S&P 500 had only 5.9%. The tech bubble did burst during this period, but both indices fell over 40% from their peak. We’re not saying the markets are going to repeat, but they may rhyme. Based on these metrics, Emerging Markets look to be quite undervalued relative to the S&P 500 and may present a potential opportunity for investors.

price to sales spread

Past performance is not indicative of future results.

price to cashflow spread

Past performance is not indicative of future results.

price to EBITDA spread

Past performance is not indicative of future results.

price to earnings spread

Past performance is not indicative of future results.

 

CRN: 2021-0903-9439 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.


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