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By Chad Karnes

Since 2011 emerging market stocks have been significantly underperforming the more traditional U.S. and European indices. In fact, over the past three years the ETF that tracks the emerging markets has underperformed the S&P 500 by over 40%.

This trend looks to be changing as some emerging market ETFs are breaking out of their two year long consolidations, outperforming the western markets the last few months.

Davids versus Goliath

The iShares MSCI Emerging Markets ETF (NYSEARCA:EEM) is dominated by Asia with 7 out of the top 10 countries in the ETF from there. Companies from China make up over 17% of the fund. South Korea is next at 16%, and Taiwan rounds out the top three with 12% of the index's weight.

Shown in the first graphic below, Brazil and South Africa round out the top five countries represented with 11% and 8%. Of the top 10 country weightings, though, Asia makes up a very large 73% of the holdings, by far the primary driver of the ETF's performance.

EEM Holdings by Country

What is also not a major factor in EEM's performance is Thailand, at only 2.1% of holdings, allowing the investors in EEM to largely skirt any political risks currently present there.

A Relative Downtrend Reversing?

The chart below shows the 40% underperformance of EEM compared to the S&P 500 over the past three years. After peaking in performance in late 2010, emerging market stocks have significantly underperformed the U.S. stock market, even though back then it was trendy for pundits to suggest buying the emerging and frontier markets.

A January 2011 headline from a popular newspaper very near the peak captures the sales pitch, "Finding Riches on the Frontier", just before a massive decline in share prices in countries like Vietnam and the Middle East. Now that the trade is no longer near as popular, it may actually be the right time to start looking at the emerging markets, especially Asia.

(click to enlarge)

Shown by the horizontal blue trendline on the chart above, recent EEM price levels were as undervalued as they have been compared to the S&P since the financial crisis in 2008. As a result buyers stepped up the last few months, driving the ratio of EEM's price compared to the S&P's to the 200 day moving average (the 40 week moving average shown on the chart).

In addition price was also oversold, just as occurred at two other price lows marking bottoms and shown in the bottom section of the chart by the blue arrows. A break above the 200 day moving average would likely confirm emerging market stocks will continue to outperform the U.S. markets. If so, it suggests EEM could outperform another 8% higher as the downtrend is eventually tested near 0.25.

Ways to Play It

There are also more specific ETFs that track every major emerging market region. For instance, the iShares MSCI Emerging Markets Latin America (NASDAQ:EEML) holds only the Latin American corporations.

Other ETFs that focus on the emerging markets are the Small Caps (NYSEARCA:EEMS) and another that holds companies solely from emerging Europe, Middle East, and Africa (NASDAQ:EEME).

The iShares MSCI Emerging Markets Asia (NASDAQ:EEMA) ETF was also recently highlighted in our subscription based Technical Forecast as having a great chart pattern, just breaking out above key price resistance levels.

A long trade on EEMA with an important price stop location was recommended with a potential upside of 14% and is the optimal choice in our opinion to take advantage of a continued relative strength of the emerging markets. The stop location provided should allow us room for profits, but also help keep any losses to a minimum.

Utilizing a stop will also allow us to recognize if our thesis is wrong much earlier than those supposed "experts" were able to when they suggested buying emerging markets in 2010/2011.

Disclosure: No positions

Link to the original post on ETFguide

Source: Are Emerging Markets Ready To Outperform?