International equities should show promise. The darling of investors during the early 90s, emerging market stocks took a beating over the last several years. By the middle of 1998, as investors were stampeding away risk, very large discount rates were applied to the future earnings of emerging market equities. As the financial storm that engulfed Southeast Asia passes, the risk premium applied to international equities will fall, bringing investors the potential of returns seen in U.S. equities as inflation premiums were reduced. Security prices increase as the discount rate applied to their future cash flows declines.
Investors benefit when the discount rates applied to the securities that they own decrease.
Profitable investing is identifying securities that have discount rates that are fundamentally high and are poised to fall. Of course, hindsight is always clearer than foresight. Long-Term Capital Management, the now infamous hedge fund, based its trading strategies on identifying mispriced securities. The strategy worked as the fund was able to buy underpriced securities and short overpriced securities. But even a team of Ph.D.'s led by Nobel prize winning economists is not always able to recognize the future direction of discount rates.