Mean Reversion in Emerging Markets

Over the short-term stock prices are mainly driven by liquidity and human emotions, but over the long-term fundamental valuation is the key variable.  This leads to mean reversion being one of the few constant rules of investing, as both liquidity and human behavioral cycles normalize over time. Over a ten-year period (approximately two investment cycles), one should expect mean reversion to run its course, and the evidence is strong that it does in emerging markets.

The past ten years in emerging markets have been dismal for investors, largely because the previous had been very good. As the chart below shows, emerging markets outperformed dramatically for the ten years leading to July-end 2008 and now have underperformed for the past ten years. By year -end 2017 the two indices were even, though during the first half of this year the S&P500 has once gain taken a small lead.

Over the long term there are only two drivers of stock performance: (1) Earnings growth, which is closely linked to GDP growth; and (2) the price-to earnings multiple, which is tied to liquidity and human emotions as well as interest rates and inflation. Current projections by the IMF and others anticipate that GDP growth for emerging markets as a whole will average about 5% for the next 5-10 years, compared to around 2% for the United States and other developed markets. This means that earnings growth in emerging markets should be significantly higher than in the United States. At the same time, P/E multiples in emerging markets are nearly half those in the United States (13.0 vs. 24.1). The combination of higher earnings growth and much lower starting multiples, all else being equal, points to relatively good prospects for emerging market equities over the next 5-10 years.

Another manifestation of mean reversion can be seen in stock leadership Every decade seems to have a few defining themes.  In emerging markets the decade ending in July 2008 was very driven by high prices for commodities. For the past ten years, the main themes have been the rise of both China as an economic power and technology as ia disruptive force. The charts below show the top ten stocks over the past three decades for both emerging markets and the U.S., with those stocks remaining on the list from one period to another highlighted in red. What we see in both cases is that market leadership constantly changes as investors shift their attention to the countries, companies and sectors experiencing the most positive narratives and best profit cycles. We can see how difficult it is for stocks to remain on the list. In both emerging markets and the United States between 80-90% of the ten most highly valued companies underperform the index for the next ten-year period as investors move on to new darlings. For the past ten-year period, of the leaders in 2008 only Microsoft outperformed the index in the United States and only TSMC and Samsung outperformed in emerging markets.

The current ten most valuable stocks in emerging markets reflect both the rise of China and the technology sector. Remarkably, seven out of ten stocks are Chinese  compared to only one ten years ago  (though Naspers is based in South Africa all of its value can be attributed to its Tencent stake) . This Chinese domination of the index occurs at a time when China faces a slowing economy, a credit bubble and unprecedented animosity from its main trading and investment partners. Last month Reliance Industries of India entered the list, replacing Ping Ang Insurance of China. Perhaps this is a harbinger of the next wave in emerging markets.

Macro Watch:

India Watch:

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  • Samsung opens world’s largest smartphone factory in India (Bloomberg)

China Watch:

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  • China’s matchmakers (Spiegel)
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  • China’s New Silk Road (The Economist)
  • Why was the 20th Century not Chinese (Brad Delong)
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China Technology Watch

  • Berlin blocks Chinese acquisition (Caixing)
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  • Wake up call for China’s chip industry (Caixing)
  • China leads the way with electric vehicles  (McKinsey)
  • A global look on Chinese robotics (ZDNET)
  • Germany impedes China tech m&a (WSJ)
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  • China’s BOE targets Apple screens (WSJ)
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EM Investor Watch

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Tech Watch

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