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Academic research has shown that "rational expectations" aren't rational. In fact they are quite the opposite and this makes markets INEFFICIENT (Expectations of returns, Greenwood & Schleifer, Investing is about facts and the perception of the facts. And it is this perception which fools us into irrationality.

When markets have performed strongly and when prices are high, investors feel good and safe and this translates into strong investment flows. However, they will be acting on the wrong kind of signal. And what follows is…poor returns. Conversely after poor performance and at low price levels (high dividend yield), flows tend to be poor (or negative). And then good returns follow!

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Today we have exactly this same pattern playing out all over again. Loud headlines are bombarding us with the end of Emerging Markets and the easy riches for investors in the Western Markets and Japan. Even most "professional forecasters" share this same view.

However, some facts need to be pointed out to properly assess the respective investment odds. The following are the investment flows for Japan, MSCI World and Emerging Markets over the last 12 months (as % of assets invested) and their respective returns.

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The picture is similar over the last 3 years. He who has flows has returns…until they turn.

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EM has been struggling because they have seen c. -$60bn leave the space over the last 12 months. That is more than all the outflows in 2008; or the inflows received in 2012, or even in 2007 during the heyday before the Global Financial crisis.

Let me just add that it's not clear to me how fundamentals would explain such divergence in flows. For example, the following chart includes total country debt and growth (implicit in GDP) as a proxy for return on that debt. Most Emerging countries are healthily at the bottom of the chart while most Developed are getting worse and worse (see also the comparison with Asian crisis levels in 1997). Venezuela and Argentina aren't included as their problems are on a different scale (Argentina in default since 2001…). It is interesting to see how the troubled Turkey had been increasing debt at a fast clip recently with most of it devoted to bringing consumption back from the future (similarly to Brazil who is suffering too). The remaining 20 plus Emerging Markets are okay.

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The bottom line is that the EM underperformance was caused mostly by sharp negative flows. And these depend on sentiment. Academic research shows that sentiment and flows are good contrarian indicators of investment returns. Therefore an intelligent investor should consider that odds today are clearly skewed in favor of Emerging Markets and act in consequence.

Source: Don't Go With The Flow And Emerging Markets Odds