Emerging markets have had a disastrous year so far. As a group, they peaked at the end of 2012 and have been mired in a persistent downtrend for the past eight months.
Despite brief rallies, they have been unable to mount any positive or sustainable momentum. This underperformance is not only pervasive in stocks, but also emerging-market bonds and currencies as well, which has led to investors fleeing ETFs and mutual funds tied to developing countries, exacerbating the selloff.
But the dark times won’t last forever, and when emerging markets recover, they could start outpacing domestic stocks.
According to Index Universe, the iShares MSCI Emerging Markets ETF (EEM) and the Vanguard FTSE Emerging Markets ETF (VWO) have lost more than $12 billion combined this year. That also puts them in the top five for all ETF outflows year-to-date. A quick comparison of EEM vs. the SPDR S&P 500 ETF (SPY) for the past 12 months shows why investors have been flocking to domestic stocks that are still in a stable uptrend.
Recently, the international picture has grown even darker, and investors have become spooked over fears that the U.S. will enter into a conflict with Syria. This will likely cap the upside potential of emerging market stocks in the near term. However, I am still looking at this region as a value play once we see some stability return.
Historically, these countries have had periods of very strong growth and can be an excellent way to diversify your portfolio outside of the U.S. In addition, these up-and-coming economies offer many attractive qualities over developed markets, which can include lower debt burdens, solid economic prospects, high levels of natural resources and a burgeoning workforce.
My preferred way to play the emerging market region is through the SPDR Emerging Markets Small Cap ETF (EWX). This small-cap ETF has performed much better than its large-cap rivals in the past year and offers investors an avenue to tap into the local consumer in these regions.
Emerging-market bonds have recently been taken to the woodshed due to a trifecta of events that have caused investors to flee to the safety of cash in the month of August: rising interest rates, currency volatility and fears over what might be the next global crisis.
Emerging-market bonds are unique because many issuers have lower overall indebtedness and stronger growth potential than domestic counterparts. However, many countries don’t have the legal system, or the long-term credibility to garner consistent investor interest. So as the global fixed-income landscape warns of trouble ahead, investments in these types of bonds are typically the very first to get thrown out of an investors’ portfolio.
Ultimately, this sector could be setting up a great buying opportunity, as investors still need consistent cash flow. With bond prices consistently falling and yields rising since late May, it appears there is no near-term bottom forming that would attract even short-term traders.
Investors would be wise to keep a close eye on a few of my favorite emerging market bond ETFs such as the iShares J.P. Morgan USD Emerging Market Bond ETF (EMB) and the Wisdom Tree Emerging Markets Corporate Bond Fund (EMCB). Look for a series of higher lows to form before establishing a position — that way the chances are higher that a strong base has been put in.
Two Ways to Play
Aggressive investors who are seeking purchases in beaten-up sectors should consider emerging markets as a potential area of opportunity. If you have a long-term time horizon and the stomach for the volatility, you might be early to an area of the market that is offering better value than domestic stocks. However, there are still many headwinds that these countries face before they are able to return to their glory days of double-digit growth.
More conservative investors might want to consider waiting until we see some additional stability before repositioning their portfolio to take advantage of this sector. I would look for emerging market stocks to break out above their August highs and hold above the 50-day moving average before making an entry. In addition, it is always a prudent idea to implement stop-losses to guard against downside risk and use the prior low as your exit point.
David Fabian is Managing Partner and Chief Operations Officer of Fabian Capital Management. As of this writing, he did not hold a position in any of the aforementioned securities. Learn More: Why I love ETFs, And You Should Too