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This Time Is Different

September 28, 2006 by  


By Bob Wood

I know, I know! We are all conditioned to run the other way when someone gives us that infamous rationale–“this time is different”–for making what can often become a bad investment decision. But now that I have your attention, let me explain: this time truly is different, and you should heed the call– and invest accordingly!

Almost every time we have heard that phrase, we have seen proven again that “different this time” rarely happens. Whatever investment environment was supposedly undergoing a meaningful change rarely endures long enough for investors to capitalize on it. As investors should now know, no absolutes exist when it comes to the markets and the irrational investors who labor in them.

But I am now completely comfortable in taking the risk to publicly say that “This time is different!” Yes, we should ignore the old and, for the most part, accurate maxim to avoid calls to invest. Oh, I fully expect that some will be waiting for “judgment” day to laugh at my ignoring the wisdom of experts by claiming to identify the rarest of occurrences: the time that will truly prove to be different!

Let me explain. If you are a regular reader, you know by now that my version of a perfect portfolio, as described in this column during the past three years, involves following secular trends. My argument back then is much the same now – investing long in international markets and short in domestic markets.

And I, studying what truly great investors have become convinced about in the past, believe that when we find better opportunities to profit, the best plan is taking large positions and patiently riding the trend until valuation concerns force us out.

So I have advised readers to do as I have been doing — loading up on international and, especially, emerging market stocks and mutual funds. To me, that means making much larger allocations into emerging markets stocks than most anyone else is likely to advise. After all, who doesn’t know how risky that asset class has proven in the past?

Well…not so fast there! Here’s where I beg to differ. The past is just that – history! And what happened before was due largely to variables that have since changed. And the way I see it, much has changed for the better in lesser-followed markets around the world. Yet, I really can’t expect you to take my word for it without offering corroborating evidence.

In the September 16, 2006 weekly edition of The Economist is the cover story, “Surprise! The power of the emerging world.” This 19-page special report touts the investing environment in places I’ve favored for the past few years, those markets known as emerging and, by the crowd, overly risky.

The reasons for optimism are listed in the first paragraph. “Last year the combined output of emerging economies reached an important milestone: it accounted for more than half of total world GDP (measured in purchasing power parity). This means that the rich countries no longer dominate the global economy.”

While this data may seem to indicate that “it’s different this time,” regarding the economic power of emerging economies, we really are seeing more of a return to the past. The article continues: ‘’There is also more than one definition of emerging countries, depending on who does the defining. Perhaps some of these countries should be called re-emerging economies because they are regaining their former eminence. Until the late 19th century, China and India were the world’s two biggest economies. Before the steam engine and the power loom gave Britain its industrial lead, today’s emerging economies dominated world output.’’

Do you see what I mean? “It’s different this time” to those with shorter views of history, but those taking the longer view see somewhat of a return to the past. So maybe it’s not at all different this time, except for those indoctrinated with flawed investment theories like diversification or asset allocation, which relies heavily on more recent history to bolster its supposed value.

While most U.S. investors believe in staying committed to their home markets and allocating the majority of their portfolios to domestic market stocks, I think there is little argument that we should be looking elsewhere with superior risk-adjusted returns as our goal. Investors should always look for better growth prospects. On that, there is no disagreement; it is never different than that!

As The Economist piece points out regarding those re-emerging markets, ‘’In the past five years, their annual growth has averaged almost 7%, its fastest pace in recent history and well above the 2.3% growth in rich economies. The International Monetary Fund forecasts that in the next five years emerging economies will grow at an average of 6.8% a year, whereas developed economies will notch up only 2.7%.

If both groups continue in this way, in 20 years’ time emerging economies would account for two-thirds of global output (at purchasing-power parity).’’

So we see here yet another of those investing fallacies that great investors like Warren Buffett have tried to refute–with little attention paid by the investor class. The concept that domestic markets are efficient and always more or less properly priced, based on all publicly available information, suggests that not only stocks, but markets also, are priced fairly, based on the fundamentals.

So it would be easy to assume that the superior growth prospects in emerging markets carry higher valuation premiums, much like faster growing stocks tend to have higher P/E ratios. But another London-based publication, The Financial Times, indicates that such is not at all the case. The Indian stock market is priced similarly to the S&P 500 on a reported basis, but lower on a forward basis. The China Shanghai market also sells at a discount to our domestic averages, like the S&P and the Dow, which are now selling at more than 20 times trailing earnings.

Another strong economic performer, Brazil, is selling at about 10 times earnings and enjoying budget and trade surpluses made possible by selling commodities to other fast growers like China and India. South Korea, Singapore and Mexico also sell at discounts to our domestic averages. And if you’d like to take a “flyer” with a small amount of your capital, consider the Thai market, selling at a relatively cheap valuation of about seven times earnings, factoring in the current political environment, of course.

Much more evidence for emerging market appeal appears in The Economist’s 19-page story than I can fit into this space. But those who find it easy to oppose my emerging markets bias will no doubt look to past political and financial instability and advise much smaller allocations to those markets. Yet The Economist points out that things are a little different this time.

‘’Financial wobbles this summer acted as a reminder that emerging economies are more volatile than rich-country ones; yet their long-run prospects look excellent, so long as they continue to move towards free and open markets, sound fiscal and monetary policies and better education.”

Amazing as it is, too many investors and their advisors recommend favoring domestic markets, where fiscal policies are alarmingly awful, where debt and liability levels are far beyond anything that can ever be repaid as previously agreed, and whose education system has been marginalized by neglect, showing American children getting rather average educations, at best.

All this evidence bodes very well, in my opinion, for thinking that it is different enough this time to take much bigger positions than “the experts” typically recommend — timid 5% to15% allocations in the fastest growing economies on the planet. Sure, those markets will tend to be more volatile, so mutual funds are likely the best course of action for most investors.

So, in the final analysis, I’m not sure whether times are truly different — or merely reverting to the way they were during the 18 centuries leading up to the 1800s. Yes, it’s certainly different than it has been in the recent past, but very much like it was for most of modern history!

Have a great week,
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., bwood44@tampabay.rr.com.

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