Are emerging markets due?

February 25, 2016 01:00 PM

Forecasting isn’t a big part of what we do at our shop; mostly because a graph of any forecaster’s predictive ability from one year to the next would show a down sloping function between their accuracy and ability to add any value to your life. After all, how many forecasters correctly predicted equity and bond returns would be flat in 2015?  Instead we study investor behavior and look for signs of herding, and in 2015 that meant you would have to be blind and deaf not to have realized that everyone went long the dollar at the same time as the Fed began raising rates while every other nation simultaneously cut theirs, and while this was too good an opportunity to pass up, there might be more value in putting your capital to work where there’s blood in the streets.  

To put things into perspective, the PowerShares DB US Dollar Bullish ETF (UUP) ended the year up over 7% compared to a slight loss for the S&P 500 but that strong return put the fund right back to the highs not seen since the financial apocalypse of 2008 and students of market behavior know that sort of extreme performance doesn’t persist over the long haul.  But the stampede into the dollar had another unintended consequence, namely driving “safe” U.S. equities into the stratosphere. Price momentum is just one factor we score but if we re-ranked our universe of 866 funds based solely on that, for much of December the 100 highest scoring funds would have had a distinctly American bent, with the foreign equity funds that made the list having a distinctly developed or Chinese orientation. In fact the predilection for “safe” U.S. equities became so extreme even S&P 500 index funds like SPY and IVV made the top 100.

With the dollar close to all-time highs and U.S. equities priced for perfection, our recommendation for 2016 is that investors look over their portfolios and plan for what could happen if the weak global economic outlook leads the Fed to prematurely halt its rate hikes.  If you flipped our momentum list to the bottom 100, the unloved funds at the bottom of the pile share a common theme, with nearly all having an inverse correlation to the U.S. dollar. MLP funds are heavily represented, but one category with a negative correlation to the buck and that has been working its way off the bottom is emerging market equities, where a momentum reversal could be underway despite a third year in the red.  Going long EM stocks is very much a contrarian play as it’s hard to find positive research but as “Fading the Fed” shows, there was a clear pattern in 2015 where the iShares MSCI Emerging Markets ETF (EEM) began to find strength while domestic equities suffered whenever the Federal Open Market Committee chose to hold off on raising rates in response to weak economic reports.    

High volatility and underperforming the S&P 500 for five straight years have done more than just make EM equities everyone’s favorite whipping boy; it’s made the asset class one of the most (relatively) attractively priced options available to investors at the start of 2016. Being cheaper than the S&P 500 isn’t much of an accomplishment these days, which is why our fundamental scores compare the current price multiples of a fund to their historical scores. We found that EEM’s current price-to-cash flow ratio is in its 97th percentile, meaning the fund has only traded at a lower multiple for 3% of its history, while the price-to-book ratio is in the 99th percentile!

About the Author

Matt Litchfield is content editor for ETF Global (ETFG.com) and is responsible for all posts and new product updates on ETFG.com. @ETF_Global