Research Affiliates: Echoes Of 1999: The Tech Bubble & The ‘Asian Flu’

April 25, 2016

Tumbling emerging market currencies. When we measure emerging market (EM) currencies on a purchasing power parity (PPP) basis, we find they have only been this cheap once before—in 1998—when emerging markets were hit by the Asian currency crisis and the Russian default. Over the last four years, as seen in Figure 2, EM currency valuations have tumbled from a 20% premium to a 21% discount as of March 2016. Today, a basket of EM currencies is trading at bargain-basement levels deep into cheapest-quintile territory. Knock-on effects abound! Cheap EM currencies translate into an improvement in export competitiveness which in turn leads to positive earnings shocks in EM equities. These earnings surprises—still ignored by the punditry!—can be very supportive of local emerging stock and bond market returns, rewarding those who hold meaningful allocations to both asset classes.



Figure 2

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Extreme relative valuations for EM versus U.S. stocks and bonds. By August 1998, the Shiller cyclically adjusted price-to-earnings (P/E) ratio (or CAPE ratio) for emerging market stocks reached an all-time low of 8.5x, trading at a 70% discount to the S&P 500 Index. Today, as illustrated in Figure 3, the discount is 60% and the EM CAPE is 10.6x. For the 10-year period beginning in 1999, the U.S. stock market's total return was essentially negative in both nominal and real terms. Compare that, however, to the 9% a year EM stocks earned over the same decade.3 The current seven-year U.S. bull-market rally has pushed U.S. valuations into the top decile historically, while a five-year bear market for EM stocks leaves them at valuations well into the bottom decile for the last quarter-century. These valuation levels historically set the stage for double-digit returns over the subsequent decade. Our forecast is for a more modest, but still quite welcome, 8% real return.4



Figure 3

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Protracted growth-stock bull market and underperforming value stocks. In the three-year trailing period ending March 31, 2016, value stocks underperformed growth stocks in the MSCI World Index by nearly 11%, hovering near the worst decile of relative performance for the two strategies since 1976. Consequently, as Figure 4 shows, value stocks are the cheapest now relative to growth stocks than at any time other than the tech bubble (1998–2001) and the global financial crisis (2008–2009). Historical experience shows that starting valuations similar to those we see today in value stocks have led to their prolonged, massive outperformance, making a strong argument for rebalancing into a deeper value tilt and avoiding the popular, bull-market growth stocks.



Figure 4

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In the first quarter of 2016, each of the four trends reversed. Recent weeks have brought rebounds in inflation hedges, emerging market currencies, diversifying markets, and global value stocks relative to growth. Do these last few weeks represent "the turn"? Perhaps. The question, however, is irrelevant because the answer is simply impossible to know. But what we do know is that if we want peak exposure to these markets when the turn comes, we must begin to "average in" in the face of adversity.

We also know that these out-of-favor markets average a 3.0% yield premium versus a U.S.-centric 60/40 portfolio, which represents a powerful performance advantage to those who can patiently wait for mean reversion's inevitable grip on the market. Once the market turns, history has shown the upswing will be fast and vigorous.

Real Potential

In the 5 and 10 years following December 1998, assets other than U.S. and developed-market equities and U.S. notes and bonds outperformed 60/40 by an annualized 8.8% and 6.2%, respectively. Developed value stocks also outperformed their growth counterparts by nearly 6% a year in the 5 years following December 1998. Are these markets poised to repeat this strong outperformance? Only time will tell, but we believe the potential is very real. Our view today is that real return–diversifying asset classes5 could improve on a traditional 60/40 allocation by approximately 3.5% a year over the next 10 years. Real return–oriented diversifiers and value strategies may not experience the same magnitude of outperformance as they did starting in 1999, but we're confident they will outperform in the years to come. Now is the time to rotate into these markets.

 

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