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Inside the Market Three pockets of the market for the value-oriented investor to watch when nothing is cheap

Bargain-hunting investors have to face facts: After a decade of rising share prices, nothing is cheap any more.

On Bay Street and Wall Street, most stocks are trading for healthy to hefty valuations. Whether you look at their prices in comparison to forecast earnings, or to historical profits, shares are more expensive than they have been at most times in the past.

Many of the biggest recent winners, such as Amazon.com Inc., Netflix Inc. and Shopify Inc., change hands at levels that seem to imply these enterprises will face no problems, ever. Meanwhile, hot new businesses – think plant-based-meat producers and Canadian pot growers – are trading for prices that assume wild growth lies ahead.

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So what does a cautious, value-oriented investor do in this environment? Maybe it’s time to stop looking for bargains that no longer exist and instead search for potential deals – pockets of the market that aren’t obviously bargains right now, but could surge given the right shift in circumstances.

Three areas stand out. Here are their pros and cons, as well as what is needed to send them higher.

Gold

Bullion has already jumped more than 10 per cent since the start of the year. Ray Dalio, the billionaire hedge fund manager, said this week that the precious metal is one of his top investment choices as markets undergo a “paradigm shift.”

Paradigm shift or not, gold has always provided anxiety relief for nervous investors. Right now, with trade wars looming, bond yields plunging and economic indicators divided on what comes next, it fills a definite need. Even more so if you look ahead to next year, when a U.S. presidential campaign could turn vicious, with market-rattling results.

Further out, lower interest rates could add to gold’s appeal by reducing the attraction of alternative havens such as bonds. Analysts at Citigroup see the metal rising to US$1,600 by 2022 from around US$1,429 an ounce now.

Buying bullion is not a one-way bet, though. The metal’s allure could fade if there is an outburst of calm after, say, a trade deal between the United States and China. Unlike Citigroup, the folks at Capital Economics see the metal falling back below US$1,400 by the end of next year.

The necessary catalysts: Trade wars! More uncertainty! Lower interest rates!

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Value stocks

Where better to find value than in value stocks? Long-term studies show value investing works. People who buy cheap stocks – ones that are trading at low multiples of their earnings and other fundamentals ­­– tend to enjoy above-average results.

There is only one problem with this happy story. Over the past decade, and especially over the past five years, value investing has turned downright ugly. In Canada, the iShares Canadian Value Index ETF has generated a meager 3.4-per-cent average annual return since 2014. Over the same patch, the S&P 500 Value Index in the U.S. has lagged behind the plain-vanilla S&P 500 by more than 2.5 percentage points a year.

Maybe it’s time to bet on a rebound. Value stocks are often duds during patches when fast-growing tech companies are all the rage, according to Man Group PLC, a large London-based money manager. Value stocks did not do well during the go-go years of the 1960s or the dot-com bubble in the 1990s. In both cases, though, they came back strong.

Perhaps they will this time, too, once investors’ current fascination with online commerce dies down. Value stocks tend to shine during periods of rising inflation and surging interest rates, when it becomes difficult to put a value on future growth, according to Man Group.

Mind you, neither of those factors offers much of an immediate reason for optimism. At the moment, inflation is well contained. Interest rates are generally going down, not up. Value investors may have to be patient for a long time.

The necessary catalysts: More inflation! Higher interest rates!

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Emerging markets

Rob Arnott, the motorcycle-riding chairman of Research Affiliates LLC, a prominent market-analysis business in Newport Beach, Calif., doesn’t mind a bit of risk. Right now, he thinks risk-tolerant investors will be amply rewarded for betting on emerging markets, especially if they tilt toward the value end of the spectrum.

Mr. Arnott argues that emerging-market stocks are generally cheaper than their counterparts in the developed world, and emerging-market value stocks are cheaper still. He argues they are an “anti-bubble” that contrasts with the bubble of unrealistic investing enthusiasm around tech stocks in particular.

Maybe so, but venturing so far off the beaten track could involve some nasty spills. Jonathan Wheatley of the Financial Times argued this week that much of the rationale for investing in emerging markets is disintegrating. Part of the problem is U.S. President Donald Trump and his trade wars. But there are also longer-run, more organic reasons for worry.

China’s growth is slowing as the low wages that drew so much industry to the country two decades ago continue to climb. The sudden, unexpected departures of Mexico’s finance minister and Turkey’s central bank governor demonstrate that governance is still a concern in much of the developing world. Meanwhile, high debt levels and lacklustre productivity growth also afflict many emerging markets.

So what’s needed for emerging markets to prosper? Trade peace, for one thing. Stronger global growth, to create demand for exports. And lower U.S. interest rates to reduce the burden of their debt.

The necessary catalysts: Trade calm! Lower interest rates! Growth!

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