Another good day for the world’s developed stock markets today, February 8. In the United States the Dow Jones Industrial Average was up 0.59% and the Standard & Poor’s 500 was up 0.42%. The NASDAQ 100 rose to its highest level since February 2001. In Europe the Euro Stoxx index was up 0.37% and in Japan the Nikkei 225 was up 0.41%.
Eight of the nine sectors that Standard & Poor’s divides the market into are now above the highs that they set last April. The ninth, the financials, is showing life and looks like it might decide to join the group.
I’m certainly enjoying that performance, but it is enough to give me pause.
Not because I think we’re in for an immediate correction. The likely news flow—continued movement toward some kind of resolution in Egypt and continued evidence of U.S. economic strength—should continue to push the U.S. market in particular and developed markets in general higher for a while even though parts of the market—semiconductor and networking stocks, for example–are looking frothy.
I’m uneasy because the evidence from global market cash flows says that one big reason for the advance of developed stock markets is the decline of emerging stock markets—and cash flows can reverse. Last week, investors added $6.6 billion to developed market equity funds. That was the fifth straight week of positive cash flow into developed market stock funds.
The other side of that move was the outflow of $7 billion from emerging market equity funds.
I can think of three reasons for this pattern in cash flows. First, the turmoil in Egypt has reminded investors of the risk in emerging economies. Second, central banks in most emerging economies are engaged in a round of interest rate increases—and central banks in developed economies such as the United States aren’t likely to raise interest rates soon. And, third, growth looks like it’s accelerating in developed economies—again especially in the United States—while it’s decelerating in emerging economies.
Notice one reason that’s missing from that group? I’m not arguing that developed market stocks are cheaper than emerging market stocks—on an absolute basis anyway. You can get a rough feel for that by comparing the trailing 12-month price-to-earnings ratio for the iShares MSCI Emerging Markets Index (EEM) at 13 with the trailing-12-month price-to-earnings ratio for the U.S. Standard & Poor’s 500 at 14.
U.S. stocks—and other developed market stocks—are only cheaper if you dock emerging market stocks for risk—all too easy to over-estimate in the aftermath of Egyptian turmoil. They’re only cheaper if you dock them substantially for those central bank interest rate increases. And they’re only cheaper if you give accelerating growth from 3.2% more weight than decelerating growth from 10.3%. (China’s GDP growth rate for all of 2010.)
So ask yourself how long those conditions persist? The answer I come up with is the first half of 2011. For that period investors will look at interest rate increases, potential risk, and accelerating economy growth and say, “I want to put money into developed markets.” But as those conditions fade, investors will go back to seeing that higher growth is higher growth.
For weeks, possibly months, I’ve been telling you that the U.S. stock market is likely to be the best performing stock market in the world. I hope you’ve heard that message. (Whether you agree or not is up to you.) But I want to make sure you hear the second part of that message to: “for the first half of the year.”
This isn’t a time to chase U.S. and other developed country stocks no matter what their prices and no matter what month the calendar reads.