Are Emerging Markets Headed Up Or Down?

This article was stimulated by interesting comments about overbought and oversold foreign markets by Birinyi Associates (Ticker Sense) , and by emerging market closed-end fund premium/discount comments by Herb Greenberg (Market Watch). Both suggested things are getting pretty “toppy” internationally.

They may be right, particularly the short-term, but I am wondering if the opposite might be coming about. This is not a prediction, but rather a questioning.

In one of my own prior articles about long-term performance of key indices, I commented that the MSCI Emerging Markets Index (EEM) has provided a breathtaking ride over the past 10 years.

So, what is in store – a terrible correction or a ride to the moon? Here are two interesting charts to wrap your mind around before you place your own bet. Whichever way it goes, our only solid prediction is that it will be fairly dramatic.

First, here is a 15 year chart of the premium/discount for both of the closed-end funds Herb Greenberg talked about - the Morgan Stanley Emerging Markets Fund (MSF) and the Credit Suisse Emerging Markets Telecom Fund (ETF) [the symbol is ETF, but it is not an ETF it’s a CEF]:

click to enlarge

The current discounts for MSF and ETF are currently negative 6.1% and negative 3.7% which compares to month-end averages since inception (15 years for MSF and 14 ½ years for ETF) of negative 8.9% and negative 12.5%. ETF has not seen so little discount since 1996, although MSF has seen this much discount in 2003, 2004 and 2005.

That would suggest “toppyness” in the emerging markets telecom sector and maybe not so much in the general emerging markets sector. Since telecom is a big part of emerging markets, if it were possible to extract the telecom sector, the remaining emerging markets discount would enlarge significantly, we would think.

On the other hand, for both the general emerging markets and the emerging telecom sector, the current narrowing of the discount could foretell a return to earlier times when substantial premiums were the rule.

Those two CEFs sported big premiums in the first half of the 1990’s (also war years), but were displaced as favorites by the internet centric sectors mid-decade. Remember that the internet took off in 1994 when online imagery became practical and the internet moved beyond text and the academic sphere into the eye-candy and online commerce sphere. Then the emerging markets took a hit in the 1998 time frame probably related to the currency crisis that rocked markets back then.

Note how as the internet fad crumbled around 2000, the discount for emerging markets began to shrink right through 9/11 to today. What if the premium of the early nineties was the natural condition for small, illiquid, difficult to access and rapidly growing markets? If that is the case, then perhaps there is a lot more UP to go – or maybe not. We are as nervous as the next guy about a big correction, because we hold emerging market stocks, but we tend to think that longer-term there’s a lot of UP left.

You can see from the chart below how more gains might be in the cards.

click to enlarge

Over the past 15 years (actually 14 years 11 months through November 30th), the MSCI Emerging Market Index has not done too much better than 10-year US Treasuries, even after some very strong recent returns. The cumulative index is way below the return for the Russell 3000 broad US stock index over the same 15 years.

If you are the mind that emerging markets “should” have performed better relative to the Russell 3000 than they did, in combination with the above discussion of the CEF closed-end premium discount over the past 15 years, you might argue that there is plenty of UP left in the catching-up process. Or, maybe not. We’d like to hear from readers about how to interpret the data.

Disclosure: Author owns EEM

Comments

[Internet2k4:]

I just don't buy the near-term comparison of EEM or BRIC economies with the Russell 3000. As national economies, they are literally 50 or more years behind the G8 economies. If you say "China" consists of a few hundred million urban coastal industrial people you lose the "emerging" aspect entirely. Here is an IMF study of relative development of world economies, including the interesting Chapter 5 data on the period 1900-2000. I particularly like Table 5.1: www.imf.org/external/p...

In my mind the prospects (good or bad) of emerging market economies have to be assessed in and of themselves, with no plausible basis for saying they are bound to "catch up" or greatly exceed, or fall well short, of developed economies in any near term. There is an unresolved question of how dependent, or not, China or any other emerging economy is on the American consumer - we may get some clues about "decoupling" from the US in 2007.

2006 Dec 28 05:03 PM

[QVM Group:]

Interesting comment, and I did read the material you recommend. The issue, I think, is that we are not talking about "them" as nations or a people, but about "us" as investors in securties relating to those countries. Because of that, I think that studying things like cyclical swings in investor attention to this or that investment theme is a relevant consideration.

2006 Dec 28 09:30 PM

[healthe:]

Although we may be in an up tick, the US financial markets have not "fully confessed their sins" and their will be more bad news. The global markets will be down next year. How badly the emerging markets will be impacted is anyone's guess.

2008 Jul 27 08:20 AM