Emerging Markets Are Leading the Charge

by Tyler Craig | September 12, 2013 8:33 am

While the U.S. stock market commands the attention of most investors, opportunity seekers should be keeping an eye on developments elsewhere in the world. The benefit of tracking trends in foreign markets from developed nations like Germany and the U.K. to emerging markets like Brazil and China is twofold.

First, given the interdependent nature of our modern-day global economy, American companies can be helped or hindered by events occurring on the other side of the world. U.S. multinationals selling their wares abroad can benefit from economic strength (or be hurt from economic weakness) emanating overseas. As such, the bullish and bearish trends in major foreign markets have a direct influence on stocks here at home.

Second, surveying the broad swath of country-based ETFs can multiply the amount of trading opportunities available to you. Surely, the analysis of a dozen different geographies around the world will yield more opportunity than sticking with a few American indices.

The positive link between the U.S. stock market and foreign stock markets can be easily tracked using a correlation study. As shown in the accompanying chart, the S&P 500 — the premier benchmark of the U.S. — and the Vanguard All-World ex-US ETF (VEU[1]) have been strongly correlated. Although the correlation has dropped off slightly over the past year — mainly because of persistent weakness in foreign markets — it remains firmly in positive territory.

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The latest stock market rally has been led by foreign stocks, particularly in emerging markets. Aided by strength in the biggest player in the emerging markets space, China, the iShares MSCI Emerging Markets ETF (EEM[2]) has changed its stripes from laggard to leader. The ongoing surge in EEM has driven the EEM:SPX ratio to a new three-month high, breaking a long-term downtrend in the process.

What’s more, four of the past seven trading sessions have occurred on higher-than-average volume, suggesting institutional accumulation.

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The time might be ripe to revisit EEM for bullish plays — particularly if you’ve been avoiding it this year because of its relative weakness. If the recent breakout is the real deal and the buying campaign continues, selloffs should remain shallow. In the short run, EEM is overbought and due for a slight breather, so consider waiting for a pullback before entering the upcoming trade suggestion.

In light of its cheaper share price, selling put options is a fairly compelling trade for EEM. By selling a put, you obligate yourself to buy 100 shares of stock at the strike price if assigned. If you’re willing to bet EEM remains above $40 over the next month, or are a willing buyer around $39.30, you could sell the Oct 40 put for 70 cents or better. The max reward is limited to the initial credit received and will be captured provided the put remains out-of-the-money by expiration. If the put sits in-the-money at expiration, you will be required to buy 100 shares at a cost basis of $39.30 ($40 strike price minus the 70 cents credit).

If you’re an unwilling buyer, and if EEM falls too much, then simply buy to close the put to exit the position sometime prior to expiration.

As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.

  1. VEU: http://studio-5.financialcontent.com/investplace/quote?Symbol=VEU
  2. EEM: http://studio-5.financialcontent.com/investplace/quote?Symbol=EEM

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