Emerging markets have been cheap for a while now. Many people (including me) have pointed this out the past few years and not much has changed. My proclivity toward cheapness means I adjust my allocation towards it – moving some US to EM – and away from expensive equity assets based on valuation. That was three years ago.
This is the hard part of investing.
Cheap assets can stay cheap or get cheaper. Or to paraphrase Howard Marks – cheap does not mean going up tomorrow.
This is especially true in the short term.
The MSCI EM index, the go to emerging market index, has been on a losing streak. Imagine putting money into an index fund that lost money in 2013, did it again in 2014, and lost big in 2015. And the years prior aren’t much better. Check the charts. It’s not pretty and doesn’t scream opportunity on the surface. Compared to other assets, I’m sure a few investors would rather avoid it.
But the crazy ones or the patient ones (we can’t always tell them apart) who hung around, saw an 11.5% return year to date. That’s better than international stocks at 1%, REITs at 5%, and just shy of the S&P 500 at 12%. Small caps are on top at 21% (I didn’t check bond indexes, but this year’s rise in interest rates suggest bonds did worse).
Asset allocation isn’t just about diversifying. It’s about steering toward lower risk, higher reward assets without the risk of losing it all. Using index funds, that means investing in a combination of different markets (US, international, or emerging) or sub-sets of markets (large caps, mid caps, or small caps) while using bonds or cash to offset unexpected periods of higher risk. Maybe you tilt toward a factor or two for good measure. And for long term investors, that means looking beyond a couple years.
History shows that cheap markets have a higher chance of outperforming than expensive markets. Said another way, expensive markets have a higher chance of bigger drawdowns than cheap markets. It doesn’t mean it will happen next year, the year after, or even three years down the road, but over the long term. In terms of risk, cheap markets are less risky than expensive ones. Cheap is not risk-free, however…case in point – EM last year.
This is about market cycles and EM has been moving toward the bottom of its cycle since 2007. Maybe this year saw the EM cycle finally turn or maybe it was a tease, I don’t know. But over the next ten years, EM is still the most likely market to outperform due to its cheapness.
This is the last post of the year. Time to relax, prep for 2017, and enjoy the holidays. The charts will be updated the first week of January. Happy Holidays and a Prosperous New Year!
- What is Your Edge? – Base Hit Investing
- Thinking Can Hurt Your Investments – L. Swedroe
- Lazy Work, Good Work – M. Housel
- The Emerging Markets Hat Trick: Time to Throw Your Hat In? – Research Affiliates
- Don’t Try to Time Factor Strategies – Morningstar
- Low Volatility is Not a Buy and Hold Strategy – ETF Trends
- Active Investing: Rest in Peace or Resurgent Force? – Musings on Markets
- The Bad Side of a Good Idea – M. Housel
- Google Makes So Much Money, It Never Worried About Financial Discipline – Bloomberg
- Basketball’s Nerd King – Slate