Emerging Markets, Not for The Faint of Heart

I am a believer in an allocation to emerging markets—stocks not bonds—but it is certainly not for the faint of heart and even there is an economic/investing  long term rationale for holding them due to risk tolerance in terms of short term movements many investors should simply not own this asset class.

Emerging Markets are a perennial source of “hot money” flows buying at the top and selling at the bottom in performance chasing,.  Add in the short term traders and you have extreme volatility especially on the downside.

So this shouldn’t be a surprise from index universe.com

[Hot ETF Topics]

EEM Bleeds Assets As Global Markets Falter

Investors this week have yanked $3 billion out of the iShares MSCI Emerging Markets Index Fund (NYSEArca: EEM), as well as money from other ETFs that canvass relatively risky pockets of the investment universe, such as high-yield debt, amid heavy selling in the past few days, especially in Japan.

Here’s a chart of EEM the emerging market stock index ETF, note the extremely high volume (scale at bottom of chart) of late and the massive spike in volume at the 2008 low…clearly this is not for the faint of heart…

Also of course one can see the big chains up through the recovery from the 2008 carsh and a disappointing recent 4 years especially compared to the SP 500

Here is the emerging markets index in green EEM) vs the S+P 500 (in blue SPY)for 10 years the growth of $100,000 investment. In other words $100,000 grew to $350,000 in emerging markets vs. $200,000 for the S+P 500

On the other hand here are  is the same comparison over the last 5 years $100,000 grew to $200,000 in the SP 500 and emerging markets did basically nothing.

Valuation Matters…In The Long Term

Of course such a large disconnect in price change creates a divergence in valuations as well.

The recent market declines in emerging markets and continued relative strength in the US market make emerging markets look quite reasonable relative to the US in terms of valuation

. Emerging markets ETF IEMG carries a p/ of just under 11 while the S+P 500 is trading at just under 15. If the bullish case for the US market is based at least in good part on potential for exports by US companies to the emerging markets…it’s hard to rationalize a decline in emerging markets because of weaker prospects for economic growth…somebody has it wrong or at least is looking short term and chasing momentum and recent market performance.

According to this article published by Bloomberg after the market close on  June 14 this low valuation has caught the eyes of some investors, Although I would be loathe to find a specific reason for a one day market move. If emerging markets move down in the next week it will hardly be related to a changed view of valuations. But the article does give an interesting relative measure of valuations.

Emerging-Market Equities Rebound After Valuations Slump

…The MSCI Emerging Markets Index added 0.6 percent to 1,008.92 in New York, after slumping the most since July yesterday. The decline drove the index down to 1.5 times net assets, compared with 1.9 for the MSCI World Index, the biggest gap since August 2005, according to data compiled by Bloomberg. ….

In my view price can deviate from value in the short term but in the longer term price reverts towards value. An article in the weekend WSJ  by Jason Zweig entitled

The Intelligent Investor: Why the Markets’ Latest Stumbles Are Good News

included the following observations on emerging markets with a similar view on valuations.

…..funds that invest in emerging-market stocks ($16.2 billion in over 20 weeks, $7.8 billion out in 15 days), emerging-market debt ($3.8 billion in, $999 million out) and Japanese stocks ($13.6 billion in, $437 million out), among other categories.

“As I visit clients world-wide, almost every single investor tells me the same thing,” says Brian Singer, who runs the $145 million William Blair Macro Allocation Fund, which invests in a variety of assets around the world. “The only place they’re seeing any opportunity is in the U.S.”

He adds, “If it’s the global consensus, you can be pretty sure it’s priced in”—meaning that the wise investor should shop beyond U.S. stocks.

Mr. Singer thinks stocks in Europe and in emerging markets have gotten much more attractive in the recent selloff. He projects future returns of up to 14.5% annually over the next eight years on European stocks (and at least 20% in the Italian and Spanish markets) and 11% on emerging markets.

U.S. stocks are at a price/book ratio—or market value relative to corporate net worth—of 2.3, or more than 10% higher than they were at year-end, calculates Ryan Larson, a vice president at Research Affiliates. The same ratio on emerging-market stocks has fallen below 1.5, from 1.6, making them more than one-third cheaper than U.S. stocks.

Over the same period, the dividend yield in the U.S. has dropped to less than 2.1% from 2.2%, even as the yield on emerging markets has risen to 2.9% from 2.7%.