Even as markets shake, investors seek the riskiest corners

Even the suddenly shaky stock market hasn’t scared people away from investments that are supposed to be some of the world’s riskiest.

In a surprising twist, investors have continued to pump money into funds that own Chinese technology giants, Thai energy companies and other stocks from developing countries. At the same time, investors have become more hesitant about U.S. stock funds, even though both have turned in losses since the market started struggling in February.

The split is notable because emerging-market stock funds have historically had higher highs — and more painful lows — during troubled times. But the preference shows how much growth investors see for companies from the world’s fastest-growing economies, where middle classes are expanding.

More importantly, a long list of big-name investors see emerging markets as offering something rare in the world: prices that aren’t too expensive.

U.S. stocks in the S&P 500 are close to their highest level since the dot-com bubble when measuring their prices against average earnings per share from the prior 10 years, adjusted for inflation. This measure is called the cyclically adjusted price-earnings ratio, or CAPE, and it was at 32 at the start of the month. Over the last three decades, the average CAPE for the S&P 500 was just 25.

It’s a result of how much better U.S. stocks have performed than the rest of the world since the bull market started in early 2009, and it’s all very reminiscent for Chris Brightman, chief investment officer at Research Affiliates, of a cycle he’s seen play out before.

In the mid 1990s, emerging-market stocks were trading at higher CAPE ratios than U.S. stocks, when investors were excited about the “tiger” economies in Asia following Japan’s lead. But the Asian financial crisis flushed away the optimism, and dollars diverted into U.S. technology stocks. U.S. stocks grew to have bigger CAPE ratios than emerging-market stocks, as the dot-com bubble inflated.

After that bubble burst, dollars once again went back into emerging markets, lured by the promise of faster growth for economies like Brazil, Russia, India and China. But the 2008 global financial crisis and worries about slowing growth in China in ensuing years caused investors to leave, and they once again diverted to U.S. technology stocks.

That’s why, two years ago, Brightman said emerging markets were possibly “the trade of the decade.” Today, he doesn’t feel any differently.

“We’re still in the same conditions which prevailed in the late 1990s, with emerging-market equities trading at half – half! – the CAPE that the U.S. market trades at,” he said.

“Yes, they were even lower 18 months ago,” Brightman said. “But so? There’s no rush that you need to think this trade is over.” Investors had a yearslong period in the late 1990s, where investing in an emerging-market stock index fund would have resulted in compounded annual returns of more than 10 percent over a decade, he said.

At GMO, the firm headed by famed investor Jeremey Grantham, who earlier in his career warned about inflating bubbles for dot-com stocks and U.S. real estate, the expectation is that high prices will prevent nearly all types of stocks from keeping up with inflation over the next seven years.

Large U.S. stocks will lose 4.2 percent annually, after accounting for inflation, for example, GMO predicts. The exception is emerging-market stocks, where GMO is forecasting annual returns of 1.9 percent after inflation.

One wild card for investors is the threat of a global trade war, as the United States and China threaten to raise barriers to commerce.

Big companies around the world, including in the United States, depend on foreign sales for major chunks of their revenue. But investors see emerging-market companies as being more vulnerable to the damage of a trade war.

That could lead to more volatility for emerging-market stocks as investors wait to see if the tough talk on trade escalates into a punishing conflict or remains just the basis of negotiations for new pacts.

Since the S&P 500 began tumbling from its record high in late January, the largest U.S. stock mutual fund has dropped 5.1 percent, through Wednesday. The largest emerging-market stock fund has lost even more, at 8.1 percent.

And even if a trade war never happens, emerging-market stock funds have a long history of much sharper swings in price than U.S. stocks, developed-market stocks abroad or bonds. Accepting volatility is a prerequisite for investing in an emerging-market fund.

That hasn’t been enough to dissuade investors, at least not yet. They put more money into emerging-market stock funds than they took out for seven straight weeks, as of April 11, according to EPFR Global. For U.S. stock funds, meanwhile, investors made net withdrawals in three of four weeks.

“If we do assume that the trade issues get resolved, emerging markets still have a really good story,” said Evan Brown, director of asset allocation at UBS Asset Management. “What you tend to see in emerging markets multi-year bear markets and multi-year bull markets. We think we’re in the beginning or a couple years into a multiyear bull market.”