Lighten Up on Emerging Markets

11/15/2007 12:00 am EST

Focus: GLOBAL

Alexander Young

Equity Market Strategist, S&P Capital IQ

Alexander Young, Standard & Poor’s international equity strategist, says emerging markets are getting pricey and he recommends taking some profits.

Due to the outstanding outperformance of emerging markets equities this year, the Standard & Poor’s Investment Policy Committee (IPC) tweaked its Model Asset Allocation ETF Portfolios to allow investors to take some profits.

In light of stellar year-to-date gains, we modestly reduced the recommended emerging market equity allocation in our conservative, moderate, and growth global asset allocations. In addition, we slightly increased our recommended developed international equity allocation. The overall international equity allocation remains unchanged.

The ETF (exchange traded fund) used to track emerging markets is the iShares MSCI Emerging Markets Index (NYSE: EEM). The ETF used to track developed international markets is the iShares MSCI EAFE Index (NYSE: EFA).

While emerging market equity fundamentals remain positive with robust economic and profit growth expected, recent gains have rendered valuations less attractive, limiting short-term upside potential, in our view.

After rallying more than 43% in the year to date through November 6, the MSCI Emerging Markets index is now trading at 14x consensus profit estimates for 2008. This represents a significant premium to developed international equities, which trade at a P/E ratio of 13.1x, and only a slight discount to the Standard & Poor’s 500, which trades at a P/E of 14.2x.

In addition, global equity volatility is climbing. An unclear outlook for the US economy and ongoing disruptions in global credit markets make continued near-term emerging-market P/E expansion unlikely, in our view.

Lastly, from a technical perspective, emerging-market equities are overextended. Investor sentiment is currently very bullish, which we think makes near-term profit taking likely.
We recommend investing the proceeds of emerging market equity divestitures in developed international equities. We believe that asset class’s lower valuations and volatility, coupled with higher dividend yields, highlight its attractive risk-reward ratio.

In addition, developed international equities have greater leverage to ongoing US dollar weakness given that two-thirds of the asset class is denominated in euros and pounds, which S&P believes will continue appreciating vs. the greenback.

Specifically we see the dollar weakening to $1.50 to the euro and $2.12 to the British pound by mid-2008. Conversely, many emerging-market countries peg their currencies to the dollar, limiting any potential currency benefit.

We cut the emerging market equity allocation in the conservative portfolio to 2% from 3%; in the moderate portfolio to 4% from 5%; and in the growth portfolio to 8% from 10%. In each portfolio, we advise investing the proceeds in developed international markets.

The overall international equity allocation remains unchanged in the conservative portfolio at 15%, in the moderate portfolio at 20%, and in the growth portfolio at 30%.

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