Why The Significant Derating Of Emerging Market Equities Is Unjustified

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 |  Includes: AAVX, BBVXF, EEM, IVV, TVIX, VIXM, VIXX, VIXY, VXF, VXUS, VXX, XVIX
by: Prieur du Plessis

The dividend yield of the iShares MSCI Emerging Markets Index Fund (NYSEARCA:EEM) recently moved above the dividend yield of the iShares S&P 500 Index Fund (NYSEARCA:IVV) for the first time since the 2008/2009 financial crisis.

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Sources: iShares; Plexus Asset Management.

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Sources: iShares; Plexus Asset Management.

The 76% increase in the dividend from EEM for the six months to June put the fund’s dividend yield on par with that of the IVV, but the continued market turmoil resulted in emerging-market equities significantly underperforming the S&P 500 Index.

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Sources: iShares; Plexus Asset Management.

The sell-off resulted in the ratio of the dividend yield of the EEM relative to that of the IVV lingering close to the peaks that prevailed during the 2008/2009 crisis.

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Sources: iShares; Plexus Asset Management.

The severe underperformance of the EEM in 2008 was justified as dividends were slashed by 30% over the following 12 months.

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Sources: iShares; Plexus Asset Management.

By comparing the EEM’s underperformance against the IVV this time round, it seems that the markets are anticipating a cut of the same proportion over the next 12 months.

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Sources: iShares; Plexus Asset Management.

Is the cold shoulder that the market is giving emerging-market equities justified at this stage? I would say not. During the 2008/09 crisis the emerging-market currency I derived at by dividing the MSCI Emerging Market Index in U.S. dollars by the MSCI Emerging Market Index in local currency terms fell by 22% and therefore contributed to the bulk of the slash in dividends. This time around, the same MSCI Emerging Market Currency Index fell by only 7%. I am not professing that further depreciation is not on the cards. What I am saying is that given the current state of affairs, the significant derating of emerging market equities is not justified in light of dividend expectations.

In previous articles I argued that the valuation of the S&P 500 as measured by Robert Shiller’s PE10 is highly influenced by anxiety levels as represented by the VIX. The relationship between the dividend yield on the IVV and VIX is another example of that.

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Sources: iShares; Plexus Asset Management.

The valuation of emerging-market equities is also influenced by financial market anxiety.

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Sources: iShares; Plexus Asset Management.

The valuation of emerging-market equities is more highly geared to anxiety than the valuation of the S&P 500 Index as emerging-market equities are derated relative to the S&P 500 Index during times of heightened anxiety.

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Sources: iShares; Plexus Asset Management.

One aspect that came to the fore in my analysis is that since the middle of last year emerging-market equities were derated relative to the S&P 500 Index before anxiety levels or market volatility increased.

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Sources: iShares; Plexus Asset Management.

It appears as if the lead time is approximately 20 trading days. With the dividend yield of the EEM remaining at elevated levels relative to the IVV, it seems to me that we can expect volatility levels as measured by the VIX to remain high and move even higher over the next 20 days.

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Sources: iShares; Plexus Asset Management.

A strong reversal in the relative dividend yield will therefore be the leading indicator for the VIX to decline. But until then the restlessness in the markets will persist and the roller-coaster ride will continue.