There is no area of the investable landscape that has the potential for a melt-up like emerging markets. Developed equities in Europe, Japan, and the US have strongly outperformed, pricing in reflation which does not exist, as nearly all recent economic data is indicating. One might argue that commodities should rally hard, and indeed they might. While the supercycle led by China investment may be over, cycles still exist that can result in tradable opportunities.
But make no mistake about it: The disconnect between emerging markets and US stocks is ridiculous. One can not make a logical counterargument to the idea that if US stocks were right about economic growth, the supplier to the US (exporting countries) would have to participate. After more than three long years of weakness, only now people are turning bearish? After central bank actions, only now people are pulling their money out? After tremendous bearishness and conviction that those markets will never rally again, only now are investors underweighting emerging economies as the below chart from Merrill Lynch shows?
This is how melt-ups happen -- amid late conviction after weakness has already occurred and for a prolonged period of time. That doesn't mean it has to start today, tomorrow, or next week. Knowing the exact moment where the turn comes is never an easy exercise. However, the setup is there. The iShares FTSE/Xinhua China 25 Index (NYSEARCA:FXI) is finally showing signs of life. The only thing that is holding back the broader theme is Brazil.
Take a look below at the price ratio of the iShares Brazil ETF (NYSEARCA:EWZ) relative to the SPDR S&P 500 (NYSEARCA:SPY). As a reminder, a rising price ratio means the numerator/EWZ is outperforming (up more/down less) the denominator/SPY. Note the utterly unrelenting underperformance the country has had since mid-October last year.
Yes, the relative trend is still down, but any kind of reversal here can result in broader movement into emerging economies. There is a price for everything in markets, and as traders/investors, the only real question that matters is whether price today has underreacted or overreacted. If it has -- as every bit of logical suggests is true -- then the fact that no one else seems to be making the aggressive long case suggests that the payout is high for a reversal trade.
Some say a broken clock is right twice a day. I have continued on the emerging market theme, and my firm, in our mutual fund and separate accounts, tried a few times last year to position in, only to get out following momentum reversal. However, being a broken clock that is right twice a day is the wrong analogy. One must consider just how right that broken clock is after the fact. If indeed a melt-up is on its way, then I'm fine with how I tell time.
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