(Bloomberg) -- The key risk for investors in emerging-market stocks is not getting caught in a slump, but exiting the rally too early.
As equities cap the second anniversary of a surge that began after the first U.S. rate hike in a decade, money managers are asking how far the gains could go. At least some losses are likely in the near term, but the big question is, will that be a temporary correction, or the end of a rally that was never supposed to happen in the first place?
There are indeed some warning signs that the market may have overheated: after an 80 percent advance, stocks are the most pricey in eight years and technical patterns have reached points that spurred declines in the past. But fundamental analysis shows there’s plenty of room for equities to continue rewarding investors.
“An over 30 percent market move would normally point to stretched stock valuations,” Edward Evans, an equities portfolio manager at Ashmore Group Plc in London, wrote in a note to clients. “However, this is not the case. Market strength has been matched by improved corporate earnings growth.”
On Jan. 21, 2016, those of us covering emerging markets at Bloomberg scrambled to write a veritable sob story: a $2.3 trillion rout that had sent stocks to the worst-ever start to a year with at least 26 developing nations in a bear market. Most analysts blamed the Federal Reserve’s rate increase for the capital flight, and predicted more losses.
Two years hence, it is an embarrassment of riches. The benchmark MSCI Emerging Markets Index has made the best start in six years, coming within hailing distance of a record. Market capitalization has never been higher, at $20 trillion. Volatility is less than half of what it was in 2016, and earnings estimates have grown by more than a third.
But here’s the nub: investors haven’t increased the premium they pay to own emerging-market stocks as quickly as analysts have raised their profit estimates for the companies. One of them could be proven wrong in the coming months, but will it be investors or analysts?
The chart below suggests an answer: actual earnings are meeting expectations for the first time in six years, which means it is the investors who have to catch up with analysts rather than the reverse.
Let’s say investors refuse to raise valuations, and continue to pay only 17 times trailing 12-month earnings -- as they do now. Still, if earnings continue to meet expectations, the MSCI index will have to rise 30 percent to maintain that valuation. That would mean the gauge crossing the 1,600 level. The index advanced 0.9 percent to 1,249.08 as of 12:53 p.m. in London Tuesday, set for an eighth straight day of gains.
As for the forward price-earnings ratio, which crossed 13 last week for the first time since 2010, investors are getting a better bargain today than they did before Donald Trump won the U.S. presidential election in November 2016. They are also paying much less to lay their hands on the the MSCI member companies than they did on average in the past 13 years for which records exist.
Of course, market dynamics can remain separated from fundamentals for long periods. A meltdown in U.S. stocks could spill over to emerging markets. For these reasons, it does make sense for investors to hedge against a potential short-term decline.
But the alignment of earnings and expectations, along with cheaper relative valuations, suggest emerging markets will bounce back yet again.
“The data is indicative of the start of a more significant rotation back to emerging markets by investors attracted to their strong fundamentals,” Evans wrote.
©2018 Bloomberg L.P.
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