Emerging markets stocks have been the premier asset class over the past five years, producing an annualized return of 33.8%, as measured by the MSCI EM Index. This equates to a 330% cumulative return, versus a 66% total return for the S&P 500 and a 138% total return for foreign developed markets stocks, as measured by the MSCI EAFE Index (see Exhibit 1).

Emerging markets stocks have demonstrated their diversification benefits as well. In the past year, as the U.S. economy has fallen into recession due to the credit and real estate busts and oil price shock, emerging economies and stock markets have powered ahead. In the past 12 months, the emerging markets index has delivered a total return of 21.9%, while developed markets indexes have produced losses, and the EM index has had a relatively low 0.65 correlation with the S&P 500.

Given the spectacular returns that emerging markets stocks have generated over the past five years, and the heightened risks confronting global financial markets, investors have a number of questions to contemplate:

1. Have emerging markets stocks become an overvalued asset class?

2. What are the return prospects for emerging markets stocks over the next five years?

3. What is the right allocation to emerging markets stocks in a global equity portfolio?

4. How can an investor manage risk in this volatile equity asset class?

5. What are the most attractive ETFs on the market today for investing in emerging markets stocks?

Have Emerging Markets Stocks Become An Overvalued Asset Class?

The valuation of emerging markets stocks has definitely increased over the past five years, but not to the degree that one might expect given the huge appreciation in stock prices (see Exhibit 2). The increase in valuations has been held in check by the rapid earnings growth for emerging markets stocks, which has exceeded 20% per annum.

Prior to the bull run of the past five years, the price-to-earnings (P/E) multiple of emerging markets stocks historically averaged approximately 75% of the P/E multiple of developed markets stocks (including the U.S.), and the price-to-book multiple averaged 67% that of developed markets. Over this period (1985-2002), whenever emerging markets valuations moved to parity or to a premium to developed markets valuations, it was a signal to reduce exposure or avoid the asset class. The traditional attitude towards emerging markets stocks was that they warranted a discounted valuation because of their greater risk characteristics, their dependence on export activity rather than domestic demand, and their propensity to suffer political and economic crises.

Today, emerging markets stocks are valued at a significant premium to foreign developed markets stocks and a modest discount to U.S. stocks (see Exhibit 2). The current 20x P/E multiple of the S&P 500 is somewhat misleading because of the heavy write-downs that U.S. financial firms have taken in recent quarters. On the basis of calendar 2008 estimated earnings, the P/E multiples of the S&P 500 and the emerging markets index are much closer, at 15.7x, and 13.9x, respectively.

In light of the richer valuations now placed on emerging markets stocks, should investors be reducing their allocations to the asset class or perhaps concentrate their international stock exposure in foreign developed markets stocks where valuations seem relatively cheap?

1 | 2 | 3 | 4 |