Introduction
Since May 2009, I have recommended investments in emerging market countries. In part, I did this to bet against the dollar. But also, emerging market countries’ growth rates were high – they had middle classes whose growing demands would get them out of the global recession far more rapidly than the “mature” Western countries. In addition, their debt/deficit rates were low relative to the US, Europe, and Japan.
What has happened? My recommendations were hardly impressive. As Table 1 indicates, the S&P 500 did slightly better than the simple average of the emerging market ETFs and mutual funds that I recommended.
Table 1. – Investment Results
Source: Yahoo Finance
What Went Wrong?
There was nothing wrong with the growth projections: emerging market countries have grown rapidly while Western nations continue to have high unemployment and growing debt. And on top of this, European banks are near collapse and the US government economic policy making has become dysfunctional.
There were three reasons my recommendations were mediocre:
- Stock market investing is a “random walk”;
- Western traders and “thin” stock markets in emerging nations;
- Panic.
Random Walks
Paul Samuelson is credited with developing the mathematical theorem showing that “properly anticipated futures prices fluctuate randomly”. That means all new information is immediately reflected in stock market prices. How immediately? With the large amount of computer-driven trading that goes on today and professionals following every company day and night, any new information will be reflected in stock prices before I get it. Picking stocks is a losing game for individuals. But many of us continue to look for an “edge”. If the random walk theory is correct, all stocks have an equal probability of going up or down. So it is not too much of a surprise to see emerging market stocks performing about the same as the S&P 500.
Western traders and “Thin” Stock Markets in Emerging Nations
Table 2 provides data on the capitalization of selected stock markets, by country. In every country, the holdings of residents far outweigh the holdings of foreigners. However, the determinants of prices are trades, and investors from the developed world are the dominant equity traders globally. Take a look at the trade ratios in Table 2, the total value of trades divided by the stock market(s)’ capitalization. Note how low they are in many emerging market countries. This means very little trading. But trades are what determine prices. So what happened in emerging markets? The Westerners bought in 2009 and sold more recently. And even relatively small trades by their standards had a tremendous impact on equity prices. Some of this trading was value driven, but as with other commodities, there has also been considerable speculative trading. Speculative trading has occurred in advanced equity markets as well, but the speculators will normally have less of an impact their because of higher capitalizations and higher trade ratios.
Table 2. – Stock Market Capitalizations, End-2010 (in bil. US$)
Source: World Federation of Exchanges
Panic
Since 2008, there have been numerous instances of global financial panic. What happens in such times? Foreigners liquidate their holdings of overseas assets. If they hold any foreign assets in panic times, they will hold US dollars.
Not Just Correlations – Look at the Betas
A number of pundits have recently remarked that stock markets are increasingly correlated: when the S&P 500 goes up/down, so does the Tokyo market. But there is another factor of equal or greater importance to investors: how much the Tokyo market rises or falls relative to the S&P 500. The Beta coefficient captures this: it gives the average percent increase/decrease other markets for any percent increase/decrease in the S&P 500. These differences are reflected in the Beta coefficients of my recommendations. Table 3 gives the Betas for my investment recommendations for the May 2009 to the end of 2011 period.
Table 3. – Betas vs. S&P 500
Data Source: Yahoo Finance
Note the high coefficients for South Africa (EZA), Brazil (EWZ), Emerging markets (EPP), Pacific, excluding Japan (EPP), South Korea (EWY), and Latin America (PRLAX). For a 1% increase/decrease in the S&P 500, they go up/down on average 30% more/less. The coefficients for China (MCHFX) and India (MINDX) are much lower, probably reflecting the high capitalizations of their markets and heavy trading (at least in China).
What Does This Tell US for 2012?
If global fear and panic continues, the market whiplashes will continue. A lot remains worrisome. As I have written, things will get worse in Europe before they get better. The US pull-out of out Iraq has left a completely unstable nation, threatening oil supplies and worse. However, the US is showing some signs of recovery. So let’s at least consider what should be done if panic subsides a bit.
Weaker Dollar
Panic is propping up the dollar. I believe even more strongly than I did 3 years ago that the dollar will weaken in future years. Despite panic and other problems that tend to strengthen the dollar, it has weakened somewhat against major currencies since May 2009. With the deficits, debt, and dysfunctional government in the US, the dollar should weaken much more. So I continue believe in betting against the dollar, and that means getting your money into other currencies/commodities.
Table 4. – Dollar Losses vs. Major Currencies
Source: Oanda
But how? Jim O’Neill and his partners at Goldman have come up with a new list of countries to consider. But since I only like 2 of his 4 BRIC suggestions, I go back to square one by looking at countries:
- with 15 million people or more;
- that have sizeable equity markets;
- that are projected to grow by 3% or more in 2011.
Table 5. – Country Growth Projections
Source: IMF: World Economic Outlook
What countries on this list bother me? Right now, the Middle East is too risky for investments. Russia is also problematic: a country that is accustomed to being run by a dictator with no history of allowing markets to work. And while there is corruption in all countries, Transparency International reports there are only 7 countries in the world more corrupt than Russia – Tajikistan, D.R. Congo, Guinea, Kyrgyzstan, Venezuela, Angola, Equatorial Guinea, and Burundi.
I have looked at Mexico relative to other Latin American countries, and it has real problems. It is running out of oil, a major export. It depends too much on the US for markets, and it has a real drug trafficking problem.
So now let’s look in a bit more detail at the remaining countries. Table 6 combines growth prospects of countries with their unemployment and inflationary pressures.
Table 6. – Economic Conditions In Selected Countries
Source: IMF: World Economic Outlook
Argentina’s inflation looks dangerous enough to exclude from further consideration.
Now let’s look at the debt and deficit problems of these countries. Both India and Sri Lanka are running large government and current account deficits. A couple of years ago, I was positive on India. No longer. Unlike China, it has not invested in needed infrastructure. Perhaps its government is too democratic to rule effectively at this time of rapid growth.
Table 7. – Debt and Deficit Problems in Selected Countries
Source: IMF: World Economic Outlook
These considerations leave us with the following 13 countries for further consideration: Brazil, Chile, China, Colombia, Indonesia, Korea, Malaysia, Peru, Philippines, South Africa, Taiwan, Thailand and Turkey. But are their markets overpriced? Table 8 provides price earnings ratios for selected country and region ETFs and mutual funds. In light of discrepancies that turned up, I have given ratios from both Yahoo Finance and CNN Money
Table 8. – Price Earnings Ratios
Putting It Altogether – What To Do?
Go back to the Betas: they are important. They mean that if financial panic subsides, emerging markets should way outperform the markets of developed nations. This will happen in large part because “big finance” from developed nations will buy them again. One other thing will happen if panic subsides: people will sell dollars. The dollar will weaken. Betting against the dollar will pay off.
When panic subsides, I will start by looking at selections in Table 8 with price-earnings ratios of 11 or less.
My Investment Position
I generally agree with the argument that trying to time investments is futile. But with what has been happening these last two years, I have pulled most of my money out of emerging markets equities, concluding that a return of 4-6% is preferable to the equity roller coaster. I own Vanguard’s Emerging Market Income Fund (TGEIX) yielding more than 6%, the less risky Wisdom Tree Emerging Market Local Debt ETF yielding 5%, and the Fidelity Real Estate Income Fund (FRIFX) yielding 5%+. For reasons discussed in an earlier article, I sometimes prefer mutual funds to ETFs.
So when is time to go back into emerging market equities? We know Washington will remain dysfunctional indefinitely. Let’s wait and see what happens in Europe and the Middle East over the next couple of months.