Why Now's the Time to Short Emerging Markets

I think the top is in, and it is time to start shorting the emerging markets.

The central premise is that the world cannot and will not decouple from the United States. If the American economy is slowing or going to go into a recession, the reverberations will be felt around the world.

Not only is America slowing, Japan is as well. And Europe may be also slowing. I believe both Japan and Europe will follow the United States.

U.S. equity markets are discounting a recession. The stock market is a notoriously poor predictor of recessions, however, and frankly, I have no idea if we are going into a recession or not. But I do know that risk is rising in the financial system, and even if we escape a recession, the secondary and tertiary after-shocks in American asset markets which are occurring now will be felt around the world. The idea that the emerging markets can escape the spreading contagion is nonsense, in my opinion.

As risk premiums rise, investors will pull back around the world, and will especially do so from emerging markets, as emerging markets are the highest beta markets. Currently, spreads on emerging market bonds are 270 bps, up less than 100 bps off their lows several months ago. In 2002, spreads were 1000 bps. We may not hit a 10% premium over Treasuries again, but I am very, very confident that the peak of this cycle is not 2.7%.

I have three criteria for shorting - the asset is expensive, fundamentals are deteriorating, and technicals are rolling over. For the first two, I am very confident. For the third, I am less so as the MSCI Emerging Markets index may still be in a bull market.

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However, the 50-day moving average has been broken, and we can fall to the 1000-1050 range and still be in an uptrend. Thus, even if one shorts here, one can still crank out 15%-20% on the short-side before covering at support if one is wrong about a bear market. But if one is right, then the gains are much greater because emerging markets will fall much farther.

And, I think they will fall much farther, but am just unsure from what level.

What gives me comfort on the short side is that when I scroll through the charts of national indices, many appear to be breaking down.

In the developed world, virtually every chart I look at is in trouble. The U.S., Canada, the U.K., Germany, France, Spain, Switzerland, Italy, Ireland, the Netherlands, Belgium, Denmark, Sweden, Austria, Greece, and Japan all appear to have topped. Only Finland looks like it is heading higher.

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Ireland

If the developed world is slowing or going into a recession, and its markets are breaking down, I highly doubt emerging markets will keep rocking.

I see many charts rolling over in the emerging markets, including Mexico, Brazil, Chile, Peru, Argentina, Hungary, Romania, Slovenia, Bulgaria, China and Taiwan, whereas Egypt, Saudi Arabia, Tunisia and Nigeria appear to be in uptrends. Most others are consolidating or maybe topping.

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China could be experiencing a bull market sell-off, as it has five times since it started its ascent in mid-2005, ranging from -12% to -21.5%. The current correction has been a decline of 22%. This sell-off, however, pails compared to the 500% the Shanghai index has gained from the bottom on June 6, 2005 to the most recent top on October 16.

Similarly, Brazil is up 600% from the bottom in 2002, Mexico 400%, Chile 240%, Peru 1500%, Bulgaria 1600%, Romania 1100%, and so on.

Thus, when emerging markets eventually crash - and they will - it will be a long descent to the bottom.

During the Asian crisis of 1997 and 1998, the MSCI Emerging Markets index fell from a multi-year high of 571 on July 9, 1997 to 236 on September 10, 1998, a decline of 58%. And the market never appreciably rebounded once it fell off its highs. It fell 16% from July to September 1997 before rebounding a few percent, then fell another 26% into January. It bounced 25% into April before collapsing 47% to its ultimate bottom in September. Currently, the index has fallen 12%.

Shorting now is tricky. In the graph above, the MSCI Emerging Markets index appears to still be in an uptrend. However, it was also in an uptrend from 1995 to the top in July 1997. It broke the lower band of the uptrend around 480 in October of that year. A similar strategy would be to short the index once it breaks through the lower band of the uptrend at 1000.

I will be entering a short position in the near future. I intend to buy the ProShares UltraShort Emerging Markets ETF (EEV). I may also buy the ProShares UltraShort China ETF (FXP).

Disclosure: It goes without saying that you should enter any position based on your own research and risk profile. Shorting frothy markets is always a dangerous exercise, especially when you do so on the advice of an anonymous blogger.

More on Inverse (Short) Sector ETFs.

Comments

[Harmonymonkey]

My bet is that you don't short, if you haven't already. Waiting a bit will likely bring more clarity on the imminent (psychological) rescue of the US markets via another Fed rate cut 12/11 - 50bp possibly - and the re-liquification of the financials. All that the emerging markets need to see is the strong response of our markets to these stimuli to return to their upward bias.