These are exciting times. There is great market volatility as investors phase in and out of panic/despair and speculators profit. But what is really important for investors has not changed: Western nations are still in a mess, while Africa, Asia, and Latin America are relatively debt-free and continue to grow rapidly.
You might argue that other factors matter, like changes in government policy and the earnings reports of individual companies. No doubt this information is important, but I am a believer in the random walk theory. That means this sort of information is immediately reflected in stock market prices. How immediately? With the large amount of computer-driven trading that goes on today and professionals following every company day and night, any new information will be reflected in stock prices before I get it. Picking stocks is a losing game for individuals.
So what to do with your money in today’s environment? I address this question by reviewing my earlier ideas, what went wrong, and what I have learned.
Since May, 2009, I have suggested investing in Africa, Asia, and Latin America because they are relatively debt-free and growing rapidly. Table 1 summarizes how they are doing relative to others. Note that the IMF projects that advanced economies will only grow at 1.6% this year, down from their 2.5% projection in November 2010 (2010 projections are included in parentheses for all Table 1 entries). In contrast, emerging market countries are expected to grow 6.4%, down by just 0.6% from last year’s projection. Government deficits? 6.5% of GDP in advanced countries and only 1.9% in emerging market countries. The story is the same with debt: only 36.2% in developing countries but 103.7% of GDP in the developed world.
Table 1. – Economic Prospects, Selected Countries, Regions
Source: IMF World Economic Outlook database, Sept. 2011
And then there are trade deficits. The US is unique among these nations with a trade deficit that exceeds 3% of its GDP. Question: Why would anyone invest in the advanced countries when prospects in emerging market nations are so much better? Recent history provides the answer.
The world has come through a rough patch:
· US banks gambling (mortgage-backed securities), a real estate bubble, the collapse of US banks, panic, massive stock market and real estate losses, and a global recession;
· More recently, European banks gambling (sovereign-debt backed securities), fear of another bank collapse, and panic.
What do these two events have in common? Whenever investors get worried and start to panic, they sell equities, hold cash (dollars preferred), and buy US government securities. Does it make sense? Is it logical in light of the economic mess the US is in? No, but that is what happens.
Evidence for this is presented in Table 2 using my previous investment suggestions. Things were not good back in 2009, but there was hope recovery was on its way. Between May 2009 and October 2010, money was made in stock markets worldwide, with higher returns in emerging markets than in advanced countries. But then, fear and panic returned. There was growing worry about European banks and the inability of the US government to govern. That was enough to cause investors to sell their emerging market stock holdings resulting in significant equity losses.
Consider my recommendations. I originally said invest in emerging markets and get out of dollars. I later suggested hedging your bets with real estate and vice. As one would expect, the hedges did not lose as much as the emerging market investments.
Table 2. – Equity Gains and Losses, 2009 – 2011
Source: Yahoo Finance
An Aside on Global Equity Markets
Table 3 provides data on the capitalization of selected stock markets. In every country, the holdings of residents far outweigh the holdings of foreigners. However, the determinants of prices are trades, and investors from the developed world are the dominant equity traders globally. So what has happened in emerging markets? The Westerners bought in 2009 and have sold more recently. Some of this trading was value driven, but as with other commodities, there has also been considerable speculative trading. Speculative trading has occurred in advanced equity markets as well, but the speculators will normally have less of an impact their because of their higher capitalizations.
Table 3. Stock Market Capitalizations (in bil. US$)
Source: World Federation of Exchanges
What to Do Next?
Let’s start with a closer look at how my investments performed relative to the S&P 500. In Table 4, I present “elasticities”. These measure the percent change in my investments relative to the S&P 500. If the elasticity is greater than 1, my investment went up or down by a greater percentage than the S&P 500. Several points stand out:
· I interpret the lower elasticities on my China (MCHFX) and India (MINDX) investments to be the result of their large stock market capitalizations (see Table 3) – Western speculators moving in and out did not have as great and impact as in the smaller markets.
Table 4. – S&P 500 Elasticity Measures*
*These were calculated via regression on daily price changes.
Data Source: Yahoo Finance.
So what do I think I know? Four things:
· The European situation won’t improve soon;
· The US governments inability to govern will last at least until the elections in late 2012;
· The growing middle classes of emerging market countries will demand more goods and services and thereby extend the high growth rates of these countries;
· Sooner or later, as the global malaise fades, capital will flow back into the developing countries’ equity markets.
So let’s take another look at my recommendations (Table 5).
Table 5. – Performance Indicators, Selected Investment Vehicles
Korea's P/E ratio has jumped with little dividend yield. I am not interested for now. PRLAX looks great, its P/E way down. Brazil? The trongest country in the world with a good dividend yield. South Africa – natural resource rich, good yield. India? I have lost enthusiasm – too much democracy. China is starting to have its own governance problems, but the economy is still growing rapidly.
The hedges: BAM is both a real estate and energy hedge. FRIFX has a good yield. And sooner or later, the US real estate market will recover. Vice – human nature: smoking, gambling and drinking will continue.
I plan to buy PRLAX, EZA, EWZ, BAM, FRIFX, and VICEX in the next two weeks.
I am not an investment adviser and nothing I say should be taken as a recommendation to buy or sell an asset.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.