Emerging Market Fat Pitch Hasn't Lost Weight: 4 Factors That Prove Thesis
Emerging market strength looks set to continue independent of whether a correction in US markets may about to occur.
This change in narrative brings to light an important question.
After taper talk began in early May, emerging market equities experienced a sharp decline of almost 20%. We were told at the time that this was due to tapering, and the negative effects that a removal of QE would have on emerging markets. If we take this explanation at face value, with tapering now off the table for the foreseeable future, shouldn't emerging market equities re-synch higher here?
While I don't believe emerging markets are as QE-dependent as we are told (they had been underperforming US equities since late 2010, all during quantitative easing), there are a number of factors supporting the thesis that we're in the early innings of EM outperformance:
1. While the S&P 500 (INDEXSP:.INX) (NYSEARCA:SPY) is up over 20% YTD and the small-cap Russell 2000 (INDEXRUSSELL:RUT) (NYSEARCA:IWM) is up over 30% YTD, emerging markets (NYSEARCA:GMM) just crossed into positive territory in yesterday's session (see the lower panel in the chart below). The only way for investors who missed the US rally to play catch-up here is to buy the areas of the market that have thus far failed to participate.
2. The momentum shift favoring emerging markets relative to the US which began in early September is still in place here. If emerging markets simply re-synch on a relative basis to the levels they were at before taper talk began, we could quickly see a period of 10% outperformance over US equities.
3. A number of emerging market countries are crossing back above the key 200-day moving average for the first time since May. Looking at the chart of Brazil (NYSEARCA:EWZ), you can see that this is occurring at the same time relative strength is improving (bottom panel). This technical improvement is important as it is likely to bring momentum buyers back into emerging markets.
4. Over the past three years, US small caps have outperformed emerging market equities by a startling 62% (see chart below). This outperformance has created a wide valuation gap. Emerging market equities are historically cheap here while US small caps are very expensive. The second chart below shows just how wide this gap is. The chart is from Jeremy Grantham at GMO; projected real returns over the next seven years (as of July 2013) are displayed. These projections are based on valuation, and in the past, they have been quite accurate. As you can see, GMO is projecting a positive real annualized return of 6.8% for emerging markets and a negative real annualized return of -3.5% for US small caps.
Bottom line? The EM fat pitch is still fat.
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