On Domestic vs. Emerging Valuation

In a similar vein to an earlier passage regarding Domestic vs. International Valuation and subsequent total return, here is a look at the likes of Domestic vs. Emerging. This is a basic way to form an asset allocation decision. It asks the question, “Based on the current difference in valuation vs. history, how should the US perform, in terms of total return, against Emerging Markets over a market cycle?”

To recap, the EV/EBITDA ratio of the S&P 500 has the EV/EBITDA of the MXEF subtracted from it; this creates a spread. The theory is this: When the spread is relatively wide, Emerging Markets should outperform, , because they are, in a relative sense, cheap. This should work for both sides of the coin.

Using the so called Acquirer’s Multiple has proven to be more useful than a standard Price/Earnings ratio, for reasons unknown. Without further ado,

spx-mxef

R-squared, the measure showing how well the regression line fits the data, is at 0.41. This means, for lack of a better explanation, that this model explains about 40% of the variability around the mean. In a world full of so many uncertainties, I’ll take this to the bank and cash it. Taking solace is one thing, but betting the farm is another; remember, this is only a guide.

Plugging in the current spread of 3.5, we can venture a guess as to the annualized out performance of Emerging Markets Index against that of Standard & Poor’s.

spxmxefymxb.png

Based on this rudimentary backdrop, history has dealt the S&P a poor hand. It looks like it will under perform, that is, if this model had anything to say about it. Using these two basic analyses, The S&P 500 looks less attractive than both the MSCI ACWX and MXEF.

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