Measuring EM Stocks’ Undervaluation

What is the degree of Emerging Markets (EM) stocks’ undervaluation relative to United States (US) equities? This paper compares long-term equity valuations for EM and US stocks using two different models, namely; market capitalisation (market cap) to gross domestic product (GDP); and by comparing current equity valuations to earnings growth. We analyse EM equities in aggregate and by country (focusing on the largest eight markets). The overarching conclusion is that EM equities are deeply undervalued compared to US equities, a result which is robust across different methods, both trading at the most attractive relative valuation levels for over 15 years. There is also significant dispersion between markets leading to excellent opportunities for active managers.

Stock valuations compared to the size of the economy: The ‘Buffett model’

In 2001, Warren Buffett said that the ratio of stock market capitalisation to nominal gross domestic product (GDP) was “probably the best single measure of where valuations stand at any given moment”. This valuation metric has returned to prominence as market participants question record high US stock valuations. Indeed, Warren Buffett has described the recent spike in the ‘Buffett ratio’ to above 200% as a “very strong warning signal of a future market crash” (Figure 1). Figure 1 shows the ratio of the broad Wilshire 5000 stock market index to US GDP, which stands at 235%. This is the highest level in 50 years and more than twice the peaks achieved in Q1 2000 and Q1 2007. In other words, market participants are trading US companies at close to 2.5x the size of the US economy.

How did we get here?

The ratio of market cap to GDP has been increasing consistently from the early 1980s as macroeconomic stability paved the way for earnings expansion above that of inflation. Lower cost of production of goods thanks to globalisation and increased automation have also supported the rise of profit margins and the value of listed companies.

The ‘Buffett ratio’ peaked in Q1 2000, just before the dot-com bubble burst, at 118% of GDP. From there, the ratio declined by half to 65% in Q1 2003, the second lowest level over the last 20 years, which was only exceeded by a decline to 47% in Q3 2009 in the wake of the housing market crash at the time. Since 2010, market cap to GDP has relentlessly increased, aside from modest corrections in 2011, 2015, and 2018, reaching 179% in Q4 2019 and then accelerating to the current high of 235% as of Q1 2021.