The Number 1 Risk For Equity Investors In 2014

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 |  Includes: EEM, EWC, SPY
by: Prasad Capital Management

Summary

The relative performance of emerging markets and the S&P 500 shows concerning long-term trends.

We believe emerging market outperformance has been anchored by China and that this has started to unwind.

It is a good time to minimize emerging market exposure.

As we've commented upon in several past articles, there are interesting long-term trends in the ratio of the MSCI Emerging Market index (NYSEARCA:EEM) and the S&P 500 (NYSEARCA:SPY). See here here, and here for the older articles.

The chart below shows the most recent data taking the ratio of these indices, and also includes the equivalent comparison for the Canadian index (NYSEARCA:EWC). In our view, the strong correlation over the past decade between Canada and emerging markets is very important for Canadian investors to be aware of.

Click to enlarge

There has been a clear upwards trend in this ratio from the dot-com bust in 2000 to a peak in 2008, and then a new peak in 2010 after a brief credit-crisis plunge. This data is a reflection of the enormous investment and growth of the emerging markets, led by China. Interestingly, the peak was actually lower than the one reached in the early 1990s, when Japan's investment bubble was burst and the so-called "Asian tigers" and "Pacific Rim" economies showed they weren't as invulnerable as everybody hoped.

Since the 2011 peak, the ratio has fallen from 1.5 to 1.0, but largely because the S&P 500 (which is the denominator in our ratio) has surged upward. Based on the previous history, a possible level for the ratio to bottom at is approximately 0.5, or 2x lower than where it is today.

We believe this falling ratio should continue because emerging market growth has been fueled by inefficient allocation of capital and excessive construction spending in China. For more analysis of the risks in "the China story," we highly recommend the BBC documentary titled "How China Fooled the World."

Looking to the future, our ratio can fall by a factor of 2 by any combination of S&P 500 increase and emerging market decrease. However, as we stated in our 2014 market outlook, market valuations are much more balanced today and it's hard to imagine an increasing S&P 500 contributing much of this ratio decrease in the future. On the other hand, it is easy to imagine an emerging market crisis pulling the ratio down significantly. In an even more pessimistic case, any fall in the S&P 500 would need to be matched by an even bigger fall in emerging markets for the ratio to continue falling. In fact, some warning signs regarding emerging markets have already been visible in early 2014.

From our perspective, this is the single most important risk for equity investors to be watching out for. While we don't pretend to be able to predict when "the music will stop," we believe it will stop, and anybody who has not designed their exposure intelligently for this will suffer when it does. There are several actions you can take to protect yourself, ranging from simply minimizing exposure to companies and currencies with high emerging market exposure (e.g. EWC, EEM, the Australian or Canadian dollar) to hedging long exposure using options on Canadian or emerging market stocks and ETFs.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.