BrettArends

They say the time to buy is when there’s blood on the streets.

Well, in emerging markets, it’s there now.

From São Paulo to Seoul, and from Mexico City to Moscow, the rivers of ink are flowing red and investors are panicking.

Bank of America Merrill Lynch says that U.S. investors have now yanked money from their emerging-market stock funds for 13 weeks straight—the longest such stampede since 2002. They’ve been pulling money out of emerging-market bond funds for 17 weeks straight.

Brazils Dilma Rouseff courts foreign investment

In her first speech to the World Economic Forum, President Dilma Rousseff sought to lure foreign investors to Brazil, where the economy is cooling down. WSJs Paulo Trevisani reports. Photo: Getty Images

Using MSCI data, I compared the prices of the emerging markets and U.S. stock indexes going back 20 years. The slump in emerging markets, combined with last year’s boom on Wall Street, has left emerging markets at their lowest valuation level, in relation to the U.S. market, since 2005—and well below the 20-year average. Emerging markets would have to rise about 20%, in U.S. dollars, to get back to their modern-day average relative level.

In other words, while U.S. stocks have been getting more and more expensive, their counterparts in the developing world have been getting cheaper and cheaper.

The Brazilian stock market now trades at barely 10 times forecast earnings, according to FactSet. It sells for less than one times annual sales, and sports a dividend yield above 4%. Stocks in Turkey are less than nine times forecast earnings. South Korea is below 10 times forecast earnings. These are inexpensive levels by historic standards.

And American stocks? They’re trading at 15 times forecast earnings.

Curiously, according to MSCI data the small-cap stocks in emerging markets have held up much better (so far) than the large-company stocks. Typically small-cap stocks are more volatile, rising further on the way up and falling further on the way down.

A hypothesis: The collapse in large-cap stocks shows the outsize influence of western investors buying into these markets through mutual funds and exchange-traded funds. Such funds typically invest mainly in large caps. So if U.S. investors are all dumping their emerging markets funds, those funds are being forced to sell all their (large-cap) holdings, driving down the price.

Should you buy?

The nervous Nellies will tell you that emerging markets may fall further. Perhaps they are right. BofA Merrill Lynch strategists believe that redemptions of emerging markets mutual funds have not yet hit “capitulation” levels.

But there again, they don’t know for certain. No one does.

But here is what we know for certain:

• Emerging-market stocks are now relatively cheap, while U.S. stocks are relatively expensive.
• Historically, the most successful investment strategy has been to buy what’s cheap and sell what’s expensive.
• Stocks are super-long-term investments, so what really matters is not what is going to happen next month or even next year, but what is going to happen over decades.
• Mom-and-pop U.S. investors, who have a long track record of buying and selling stocks at the wrong times, are heavy sellers of emerging-market stocks.
• Money managers, who loved emerging-market stocks when they were expensive two years ago, now hate them.
• “Emerging market” economies are not a fad. They account for a large and growing percentage of the global economy. According to the International Monetary Fund, they now account for about 40% of the world’s gross output when measured in U.S. dollars—up from less than 25% a decade ago.
• Emerging markets generally are under-represented in the “global” equity indexes. Bank of America estimates emerging market stock markets account for just 10% or so of the world’s stock markets by value.

So even if you are not trying to “time” the markets, and you just want to maintain a portfolio of stocks with the maximum diversification, you should include a hefty dose of emerging markets stocks in that portfolio. And if you haven’t recently “rebalanced” your portfolio, simple logic says you should take some of the profits from your booming U.S. stocks and use the proceeds to buy some more emerging markets stocks. And to hell with the scary headlines.