Robert Arnott on Emerging Markets

Bob Arnott well know figure and creator of Fundamental Indexing had this to say about emerging markets in an interview with indexuniverse.com

IU.com: Interesting. Any other thoughts you might want to share that I've not even come close to touching upon?

Arnott: Well one thing that I think is fascinating is we’re in a business where customer demand evaporates as soon as there's a bargain.

What's going on with emerging markets, you’ve got emerging markets trading at a Shiller PE ratio of 13 when U.S. stocks are at 24. Back in 2007, emerging crested at 37 Shiller PE at a time when U.S. was at 26. So it's been a complete about-face, from an 11 points higher price to 11 points lower price. And now people are scared of putting money into emerging markets. To me, this is a wonderful-—this is the closest thing to low-hanging fruit I've seen in the global stock market since February 2009.

IU.com: Right. It’s all about expected returns. And they sure outsize there in the emerging markets, is what you're saying, right?

Arnott: Exactly. And most investors simply extrapolate from the past. Emerging markets have been pretty disappointing for three years. And they’ve been downright awful for six months, and downright scary for two months. So people look at that and say, “I didn’t sign up for this. I'm outta here.”

The correct response should be, “These are interesting prices—unless I want to postulate that a China slowdown turns into a China meltdown, and conflict in Syria and Egypt turns into a Middle East conflagration; are those things possible?” Of course they are. That’s why we’ve got bargains. Are they likely? Maybe not. Are they likely to have an effect that spans the whole emerging economy of the world? Absolutely not. But it’s affecting pricing all over the world.

Now, add to that the fact that growth has beat value in emerging markets by upwards of 1,000 basis points this year to date, and a Fundamental Index is looking really cheap. Fundamental Indexing for emerging markets is currently priced at a 9 Shiller PE ratio.

IU.com: And are the numbers apples to apples when you look at the Shiller PEs? Or do they have a different scale altogether?

Arnott: Well, a Fundamental Index clearly has a value tilt. So the presumptive growth rate is going to be slower. But the valuation multiple is one-third off of a market that’s already nearly half off relative to the U.S. To me, that’s a really easy investment choice. It’s not a comfortable one, but you don’t get rewarded for comfort.
_________________________________________________________________

On the other hand investors seem to be moving their international investments away from emerging and into developed markets

The two largest emerging markets ETFs—the Vanguard FTSE Emerging Markets ETF (NYSEArca: VWO) and the iShares MCSI Emerging Markets ETF (NYSEArca: EEM)—have lost more than $11 billion in assets in 2013.

On the other hand, the Vanguard FTSE Developed Markets ETF (NYSEArca: VEA), the PowerShares QQQ Trust (NasdaqGM: QQQ), the SPDR S&P 500 ETF (NYSEArca: SPY) and the iShares MSCI EAFE ETF (NYSEArca: EFA) have collectively seen more than $13 billion in inflows over the first seven-plus months of the year.