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Emerging Markets Vs. Domestic Stocks: Which Has More Upside Potential?


Emerging markets represent a unique value proposition when compared to domestic stocks at all-time highs. Here's proof.

Emerging markets have been mired in mediocrity for the majority of the year. They have seen periods of extreme underperformance interlaced with brief bursts of strength that often fizzle out. Most recently, the iShares MSCI Emerging Market ETF (NYSEARCA:EEM) has been whipsawing right around its 200-day moving average without any clear directional trend. However, there is still a case to be made for adding to these regions as a value opportunity that may have more upside potential than domestic stocks. The key is selecting the right region, fund, or strategy to achieve the results you desire.

A quick check of the scoreboard will reveal that the SPDR S&P 500 ETF (NYSEARCA:SPY) has gained more than 28% this year, while EEM has languished near the flat line. This level of outperformance is stunning considering that most emerging market countries are considered to have much faster paced GDP growth than here in the US. However, the combination of tepid economic data combined with widespread currency devaluations have put a lid on emerging market upside.

Certain countries are starting to take note, as China just recently proposed sweeping reforms to boost its economy with an emphasis on finance and consumer sectors. This news sent the iShares FTSE China 25 ETF (NYSEARCA:FXI) soaring more than 3% on Monday as Chinese stocks surged to their highest levels in six months. If the reforms are implemented correctly, it could be a step in the right direction toward returning the Asia region to double-digit annualized growth rates.

My preferred method of investing in the China region is through small-cap stocks via the Guggenheim China Small Cap ETF (NYSEARCA:HAO). This fund is comprised of 251 small-cap stocks centered in China and Hong Kong with over $200 million in total assets. Since the beginning of the year, HAO has outperformed FXI by over 11%.

HAO is trading very near its 52-week highs and has been in a strong uptrend since its June lows. Small-cap stocks are an excellent way to get exposure to growing segments of the economy that are often overlooked because of their relative obscurity. In addition, with HAO you avoid many of the mega-cap China stocks that are dominated by state-run enterprises.

Another interesting observation in the emerging markets space has been the increasing correlation between equities and bonds. A quick overlay of EEM alongside the iShares JPMorgan USD Emerging Markets Bond ETF (NYSEARCA:EMB) shows just how similar the two asset classes have been trading lately. Clearly EMB is driven more by risk appetite for yield rather than more traditional interest-rate sensitivity.

Income seekers who are looking to increase their international exposure should be aware that this correlation will likely continue moving forward. Risk in emerging market bonds will likely be linked to the success of both equities and currencies along with credit fundamentals.

I believe that emerging markets represent a unique value proposition when compared to domestic stocks at all-time highs. Over the last several months I have been adding small positions in the iShares Emerging Markets Minimum Volatility ETF (NYSEARCA:EEMV) for clients in my growth portfolio as a broad-based core international holding. In addition, for aggressive income investors, I have been purchasing the Western Asset Global High Income Fund (NYSE:EHI) as an actively managed fixed-income play.

Overall I will be watching these regions closely for follow-through on the recent strength and not hesitate to exit the positions if we see a change in momentum.

Read more from David Fabian, Managing Partner at FMD Capital Management:

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Twitter: @fabiancapital
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Positions in EEMV and EHI.
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