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Emerging Market Tide Has Changed

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Recent sentiment, specifically in regards to emerging markets and emerging market equities, has shifted.

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As I've said recently in my videos and in my posts on China, the tide of sentiment has turned against emerging markets and emerging market equities.

You can see it in the performance numbers. For 2013 to date, the iShares MSCI Emerging Markets ETF (NYSEARCA:EEM) was down 9.30% while the SPDR S&P 500 ETF (NYSEARCA:SPY) was up 21.01%. Quite a trouncing for an emerging market index that was up 69.9% in 2009. From 2002 to its peak in 2007, the emerging markets index was up 320%.

You can see it in the cash flows. In June, $9 billion flowed out of ETFs that invest in international equities. The most unpopular ETF of all? The iShares MSCI Emerging Markets ETF, which saw outflows of around $4.4 billion.

And you can see it in the headlines. Here's one from the Financial Times on July 27: "Book closes on the EM growth story." Or how about this one from Bloomberg on July 22: "BRIC Bust Seen in Emerging Market Discontent With Growth."?

So what do you do? Do you go contrarian and load up on an unloved asset because it is unloved? Do you follow the crowd and stay as far away as you can - until you see evidence that sentiment has turned? Do you wait as patiently as you can - with cash on the sidelines - until the current dislike turns to absolute hatred and then buy, hoping to catch a bottom in a historically volatile sector?

This isn't exactly an academic question for me. The mutual fund I manage, the Jubak Global Equity Fund (MUTF:JUBAX), had a little more than 20% of its stock holdings in emerging markets as of the end of May. The past performance of emerging markets matters to me - and figuring out the future direction of emerging markets is perhaps even more important.

I've been thinking a lot about the issue lately. And while I don't have any definitive answers, I do have something like a framework for looking for an answer.

I think the problem of emerging market performance - and the related issue of the negative sentiment on emerging markets - needs to be broken into three parts.

First, there is the objective data showing a slowdown in economic growth in such major emerging markets as China, Russia, India, and Brazil. (That pretty much covers the BRIC countries, right?) China, which used to do a reliable 9% or 10%, looks headed down to the official target of 7.5% or less. (You don't have to search hard for an economist with a forecast of 7% or lower these days.) Brazil, to take another example, grew at a 7.5% rate in 2010, but at only 1.3% in 2012. The world's developing economies will grow by 5% in 2013, the International Monetary Fund projected recently. That's well below the 6.6% average annual growth of the last decade.

Second, I think there's an objective/subjective problem that makes this slowing more disconcerting than a drop from 6.6% growth to 5% might be in other contexts. We've gotten used to thinking of the high GDP growth in developing economies, such as China, as the reason to invest there. China is growing at 9% so I've got to put money in Chinese stocks. (This shorthand way of thinking comes, despite persistent evidence that there isn't a solid connection between GDP growth rates and stock market performance. Just look at the performance of the S&P 500 (INDEXSP:.INX) recently, during a period of economic growth in the United States that's below trend for a recovery.) And we've gotten used to seeing a relatively small number of big cap stocks as proxies for the outperformance of developing markets. Vale (NYSE:VALE), BHP Billiton (NYSE:BHP), and Rio Tinto (NYSE:RIO) are some New York listed big caps that represented an easy way to buy the emerging markets story. You can find other representatives of the most popular stocks for investing in the emerging markets story, by looking at the top ten holdings of the Vanguard FTSE Emerging Markets ETF (NYSEARCA:VWO): China Construction Bank (HKG:0939), China Mobile (NYSE:CHL), Industrial and Commercial Bank (HKG:1398), Taiwan Semiconductor (NYSE:TSM), America Movil (NYSE:AMX), OAO Gazprom (MCX:GAZP), CNOOC (NYSE:CEO), Bank of China (HKG:3988), and Tencent Holdings (HKG:0700). When these stocks have faltered, it's felt as if the emerging markets sector is faltering.
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No positions in stocks mentioned.
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