McCall’s Call: Looking For P/E Bargains

The recent sell-off in global equity markets has pulled valuations down to levels that make it hard for investors to ignore. That said, even though stocks may look cheap based on historical numbers, investors have yet to begin buying in earnest.

Matthew D. McCall

Most investors have difficulty picking individual stocks in
developed markets and even more trouble in emerging markets. That's
why ETFs loom so largely as the best and least expensive option for
most investors looking to take advantage of the high-growth
potential of the emerging market countries.

As I like to say:“Stocks are cheap, but they can always get cheaper." Ideally, the best setup for low valuations, as measured by price/earnings ratios, would be a rise in earnings. Still, pullbacks in the market do create buying opportunities.

The truth is, investors can now find low valuations in developed as well as emerging markets.

I happen to think the better opportunities are in the developing world where, on balance, risks to investors are not as significant as they are in places like Europe or the U.S.

For ETF investors, that points to funds canvassing places like Brazil, or looking at the broadest funds in the developed markets.

Developed Markets

The troubles in Europe have caused the major stock indexes in the region to drop into bear-market territory, meaning prices are at least 20 percent off their highs.

Even the eurozone’s largest economy, Germany, is down 20 percent in 2011 and down 27 percent from the early May high, as measured by the DAX Index. As a whole, the Europe MSCI Index is down 12 percent for the year.

When developed countries from North America and Asia are added into the mix, performance improves slightly, in part because of countries such as Canada.

The MSCI World Index of developed markets has fallen 9.6 percent in 2011. The selling has lowered the 2011 P/E estimate down to 14.4, and based on 2012 earnings estimates, it falls to 12.0.

Anemic Growth

Both this year's and next year’s P/E numbers are undervalued when based on historical trends, which makes it tough to not begin considering whether to buy some equities ETFs.

The one major issue that concerns me in developing markets is future growth potential.

Most growth estimates for the U.S. and Western Europe are flat to minimal in the coming years and therefore don’t make valuations as appealing. Banking issues in Europe are to blame, as are debt issues in the U.S. and an overall lack of confidence in developed nations.

While the fundamentals will eventually lead investors to buy the most attractive asset class, which history tells us is equities, timing can be tricky.

As I mentioned, stocks are generally cheap in the developed markets, but that doesn’t always coincide with the bottom of the stock market.

Emerging Markets

If I simply looked at the numbers, emerging markets would definitely be more attractive than developed markets. Perhaps that’s no surprise, but the idea that emerging markets are the less risky of the two choices might be.

The MSCI Emerging Markets Index trades with a 12.6 P/E ratio based on 2011 earnings, and a surprisingly low 10 times earnings based on 2012 estimates. Add in the estimates for earnings growth in the emerging markets of about 13 percent, and the numbers point to a buying opportunity.

The MSCI Emerging Markets Index has fallen around 15 percent in 2011 and 20 percent off the May high.

While many analysts described the pullback in the developing markets as the end of the bull market for the index, people like me believe all the selling has created a great buying opportunity.

Good growth prospects and attractive P/E ratios make the emerging markets attractive.

And, crucially, most banks in the region aren’t dealing with the same issues as those of the developed nations—whether it be the protracted aftermath of the U.S. mortgage crisis or, as is the case of Europe, huge holdings of unreliable debt issued by profligate countries such as Greece. The absence of these factors alone lowers the risk of emerging markets dramatically.

As far as risk is concerned, any double-dip recession in the developed world will affect the emerging markets too, as demand for their goods and commodities fall.

But if growth in the developed market only slows and doesn’t lead into another recession, as I think is likely, emerging-markets equity investments will shine even more.

EWZ, SPY And Beyond

Investors searching to gain exposure to the emerging markets, while at the same time not taking on above-average volatility, have an option in the world of ETFs.

The EG Shares Emerging Markets High Income Low Beta ETF (NYSEArca:HILO) invests in 30 emerging market stocks that have a lower beta versus their peers, and the index currently yields a very attractive 5.5 percent. The combination of exposure to emerging markets, high income and lower-than-average volatility sounds like a real winner to me.

Of the major emerging markets, Brazil may be the most compelling. The iShares MSCI Brazil Index ETF (NYSEArca:EWZ) is down over 21 percent in 2011 and recently traded at its lowest level in over two years.

Even though another downturn would affect Brazil, the Latin American darling has low unemployment and isn’t very dependent on the U.S. for exports. It’s also hosting the FIFA World Cup soccer tournament in 2014 and the Summer Olympics in 2016, which will fueling expansion throughout the economy.

That said, funds like EWZ have borne the brunt of selling when fears of a global double-dip recession began to surface. That has left EWZ with a 2012 P/E estimate of 7.6 and a 2011 price-to-book ratio of 1.2. In other words, it’s looking attractive from a valuation standpoint.

In the developed markets, I like to keep it simple, going with the SPDR S&P 500 ETF (NYSEArca:SPY). The ETF tracks the performance of the 500 largest stocks in U.S. and gives investors exposure to the world’s largest stock market.

Based on lower-end earnings estimates ($100) for 2012, the index is trading with a forward P/E ratio of 11.6, well below the historical average. I don’t think a 20 to 25 percent jump in SPY’s price in the next 12 months is out of the question, if the earnings estimates stay in line.

I’ve been pounding the table the last few weeks about the dangers of emotionally charged selling, which is almost always a bad investment decision.

Instead, look at the numbers and charts that are available and make educated decisions on when to buy and sell.

It seems to me that right now the numbers indicate stocks are probably cheap. If you ever want to own stocks, now could well be the time. But please, keep in mind that stocks can get cheaper before they turn higher.

Matthew D. McCall is editor of The ETF Bulletin andpresident of Penn Financial Group LLC, a New York-based wealth management firm specializing in investment strategies using ETFs.

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Copyright ® 2011 IndexUniverse LLC . All Rights Reserved.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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