PE and Earnings....

The difference, however, is that emerging-market companies are far cheaper. The EM index’s price-to-earnings ratio is 13.3 based on 12-month trailing earnings per share, compared with 21.1 for the S&P 500. That difference is even more stark when looking beyond one year. The EM index’s P/E ratio is 14.7 based on 10-year trailing average EPS, compared with 29.5 for the S&P 500.

To see why that’s important, consider the long history of P/E ratios in the U.S. The average P/E ratio for U.S. stocks based on 10-year trailing average earnings has been 18.6 since 1881, with a standard deviation of 7.3. Those numbers imply that roughly 95 percent of the time, the P/E ratio will land somewhere between 4 and 33. (For stats aficionados: Those P/E ratios aren’t normally distributed, but they’re not far off, with skewness of 1.3 and kurtosis of 2.4.)

It makes intuitive sense that P/E ratios should fall within that range nearly all the time. A P/E ratio of 33 translates into an earnings yield of 3 percent. Many investors would balk at such a low yield and turn to bonds, which would curb further valuation growth. On the other side, a P/E ratio of 4 implies an earnings yield of 25 percent. There aren’t many investors who would pass that up, which would keep valuations from sinking further.

The data for emerging markets is limited, but so far it has closely hugged the range implied by historical P/E ratios in the U.S. Since December 2004, the EM index’s P/E ratio has hit a high of 36.5 in October 2007 and a low of 10.1 in February 2016. Comparable numbers for the S&P 500 during the same period were 30.4 in January of this year and 11.9 in February 2009.

All of that translates into different potential payoffs for U.S. and emerging-market stocks. The price of the EM index would have to decline 73 percent to reach a P/E of 4, compared with a decline of 86 percent for the S&P 500. On the other hand, the EM index would have to increase 125 percent to reach a P/E of 33, compared with just a 12 percent gain for the S&P 500.