Opportunity in Emerging Markets Amidst This Panic

September was one of the worst months on record for individual and professional investors alike.  By the end of the first week in October, stocks dropped to new bear market lows and credit markets remained in a state of disorder, despite Friday's passage of the Treasury's bailout package.

Current panic conditions present an opportunity to increase our exposure to equities.  We are establishing a 4% position in the Vanguard Emerging Markets ETF (VWO) in our Conservative Growth portfolio, and increasing our exposure from 5% to 8% in our Moderate Growth and Aggressive Growth Portfolios.

Buying never feels comfortable in conditions such as these, but that is precisely how good investors are rewarded over time - by having the conviction to increase exposure when everyone is running for the exits late in a bear market, and reduce exposure when everyone is aggressively taking on risk late in bull markets.

We believe that we are at or near a panic bottom in global equity markets, and that the recent dramatic sell-off has created a good buying opportunity in stocks, and particularly emerging markets stocks. Emerging markets stocks, as defined by the MSCI Emerging Markets Index (the index VWO tracks), are down 48% from their peak, versus a 30% peak-to-trough decline in U.S. stocks.   At current prices, the MSCI Emerging Markets index is valued at just over 10 times trailing earnings. Unlike the U.S., Europe, and Japan, emerging economies are not in recession, and are in fact continuing to grow at a healthy pace.  The IMF estimates that GDP growth in the developing world will be 7% in 2008.  Relative to their growth prospects, which are much superior to those of developed economies, emerging markets appear particularly attractively valued at this time. 

We would add the following points about emerging markets:

1. Emerging markets stocks currently account for 11% of the world's stock market value, so an investor who wished to construct an equity portfolio that resembled the world's market capitalization would give an 11% equity weighting to emerging markets.  Emerging markets account for 30% of global GDP, so one could make a strong argument that the equity portfolio weighting could be even higher.

2. Emerging countries are home to 85% of the world's population and 75% of the world's natural resources.  Approximately 70% of the world's GDP growth over the next two decades is expected to come from emerging markets.

3. Emerging markets are not as exposed as developed markets to the bursting of the credit bubble because they have not been nearly as reliant on credit growth - at the household, government and corporate levels - to fuel their growth in recent years. Financially, emerging markets are creditors to the global economy, collectively amassing huge annual current account surpluses and controlling three quarters of the world's foreign exchange reserves. 

On a final note, we think the current hysterical fear-mongering among the news media and politicians about the prospect of another Great Depression is overblown, ridiculous and irresponsible.  Yes, we have paid and will continue to pay a heavy price for our financial excesses, but the idea that the economy is entering a state anywhere close to the Great Depression is absurd.  Keep in mind that virtually all of these people now proclaiming that the world's economy and financial markets are plunging into the abyss were either oblivious or complacent about the problems that led us into this crisis. 

Historically speaking, it's usually the universal recognition of recession and bear markets, accompanied by the dire headlines that things could get far worse, and the resulting investor fear and panic that often creates the final market bottom. It is entirely possible that markets, which are a manifestation of mass psychology, are today discounting the worst-case scenario.   It is not out of the realm of possibility that this could turn into a once-in-a-century financial and economic Armageddon like the 1930s, but that outcome is extremely unlikely. 

 

Comments

[Rhunzzz:]

The problem is - neither VWO nor EEM will rise again till US investors start regaining their optimism, no matter how well the actual emerging market countries are doing macroeconomically (with regards to growth or balance of payments). So in the meantime, it's a real leap of faith - neither VWO nor EEM really pays out sufficient dividends to bolster fragile faith with cold hard cash.

2008 Oct 06 10:32 AM

[irondoor91:]

Frear is a natural reaction, and it has a positive intention; to protect yourself from danger. It originated thousands of years ago when man saw others of his species running in panic. He didn't stand around waiting to see if it really was a saber-tooth tiger. He just ran with the herd that had alerted him to potential danger as he had been trained to do.

On the other hand, when man is hunting for game he applies patience, cunning, stealth and a small group with killing tools. He knows better than to charge in the direction of his prey. As he becomes better equipped to kill, many gain complacency and the highly skilled begin to supply others with meat as they become dependent on his hand-outs.

But those who became complacent and dependent lacked survival skills. They were out of shape and couldn't escape.

Sound familiar? It should, because we are seeing it play out today in our citizens who are sitting on their portfolios and 401-k's like deer in the headlights. "It'll come back" is the refrain. Don't panic. Diversify. etc.

By the time this decline accelerates down past the 8500 level, true panic and the herding instinct will set in. But it will be too late for many. They left too much of the decision making up to others and had let any skill in it that they should have acquired before investing wither away. All they have left now is either indecision or panic.

2008 Oct 06 10:46 AM

[who:]

fear is real...credit crisis spreading across the pond to europe...financial institutions requiring bailout has just started to snow ball...asian fi's are also starting to feel the impact with losses in investments...

2008 Oct 06 11:33 AM

[Jackson Cash:]

This commentary is pure speculation. Why not just come out and say "I see the bottom" like the countless other quacks writing to write.

No way Jose' would I recommend anyone jumping into international until domestic confidence is restored OR more evidence of decoupling of the US with the rest of the world is seen (over time).

For disclosure I love emerging markets, they have been good to me.

2008 Oct 06 11:54 AM

[usmctpdog:]

There is no place to hide in stock allocation, this is true and when this is over in a few years as it will be as "This too shall pass" I will have bought more as I am doing now with all my broad ETF's including, VTI, VXF, VWO and ADRE.

2008 Oct 06 12:32 PM

[Chris B:]

wyosteven,
The action that the author is taking and defending is increasing portfolio exposure to int. equities by 1-3%. In other words, barely dipping a toe in. If the market drops even more, the author will probably take another nibble. If today IS the bottom, the author will live a lifetime of regret for not jumping all in. Fortunes are made at times like these, and stocks are being put on sale, then on clearance, then on 'absolute liquidation!' and so on. The name of the game is figuring out what won't be cheaper next week. Get it wrong and you might have to watch prices drop another 10-20-30% before beginning their inevitable long rise.

I agree with the author that all this depression talk is a bit wild-eyed. It seems like most commentators and investors simply look at the last 4 months or so and declare that pattern to be the future.

2008 Oct 06 01:09 PM

[Jackson Cash:]

Chris B - I agree, now is opportunity, but not for recommendations.

Fortunes "can" be made in times like these, but just as much "can" be lost.

I love the emergings, and will go long as soon as I feel there is something worth taking a stance on. Wild 7% swings in equity markets worldwide are not a sign of confidence to go long, particularly as the global liquidity catastrophe is beginning to get in the spotlight.

I for one have been saying that this correction has been coming much longer than 4 months, and we won't even begin to see clearly until the DOW is around 8500. There is no end in sight for emerging exposure at this point, and you are simply throwing your money away (short term).

Not to worry.

2008 Oct 06 01:41 PM

[User 265729:]

Pardon me, but in another few months, we will be an "emerging market."

2008 Oct 06 01:46 PM

[Simit Patel:]

No doubt emerging markets are where it's at, though the problems with the US economy are far from over. The tax base is diminishing and government spending is increasing; this growing budget deficit, coupled with a trade deficit, is a recipe for currency devaluation. The dollar's struggles are at the heart of the US economy's problems, and in spite of this short-term rally, the fundamentals remain unchanged; if anything, they've worsened. Those who understand that the current economic situation, like the Great Depression of the '30s, is a result of terribly monetary policy by the Federal Reserve, know this. First comes the boom, then comes the bust. Last time around it was the Roaring 20s and the Great Depression; this time around it was the tech stocks bubble and housing bubble followed by the massive credit crunch (which the Federal Reserve is making worse through its deeply inflationary efforts, just as it did during the Great Depression).

A sound portfolio will be in precious metals, commodities, emerging markets, and foreign currencies. Yes, now is a great time to buy as the dollar's strength won't last too much longer. 2009 is going to be a year to remember.

2008 Oct 06 02:03 PM

[pitaking:]

The only trade in EM is the EEV(double short), on any rally it is a screaming buy for traders. $90 to $140 in less than 10 days. The trend is your friend in EEM and the trend is broke big time.

2008 Oct 06 02:46 PM

[The Sane In...:]

Although you note that ¨the MSCI Emerging Markets index is valued at just over 10 times trailing earnings¨, that only means that the fund is undervalued by historical valuations. That however doesn`t help you that much in determing whether the markets are going to fall much further.

I´m currently abroad in Argentina, and after spending a whole lot of time learning about emerging markets, it´s not really a case of whether the market that you´re investing in is in a recession, it´s more about what the people that invested in those countries are doing with their capital. Emerging markets have always been seen as a risky investment, and I can guarantee you that we´ll see huge flights of capital as people continue to panic. Economies can´t grow without capital, and that in turn fuels recession.

This is going to be the case especially in countries like Brazil that experienced huge booms in capital, since the sucking away of capital will leave that country all the more hurting (i.e. Boom Crash theories). These are export driven economies, and they can´t grow if international consumption isn´t growing. Thus, you can´t look at these markets as isolated situations. Consumer confidence in the U.S. influences these countries´ economies way more than we would like to think, and I really don´t think that people really appreciate how significant emerging market growth hinges on world capital supplies and general consumption.

At this point, calling a bottom in any market, not to metion emerging markets, is like trying to catch a falling knife. Have fun with that.

2008 Oct 06 03:22 PM

[buyitcheaper:]

Most of the emerging markets rise correlates to the dollars decline until that reverses those markets are dead.

2008 Oct 06 06:20 PM

[Mr Doji:]

"It is not out of the realm of possibility that this could turn into a once-in-a-century financial and economic Armageddon like the 1930s, but that outcome is extremely unlikely".
I think you might be in the DENIAL phase.

2008 Oct 06 06:28 PM

[Timmothy Posey:]

Today I dipped my toes in the water so to speak by buying 10 more shares of BIK (a low-expense BRIC etf). This magical $140 seems pretty low right now, but I am on a 15-20 year time frame, and I expect dramatic reversal of fortunes. Do I think I properly picked the bottom? By no means did I even try, but tried-and-true techniques such as dollar-cost averaging do play a big part in a long-term portfolio.

2008 Oct 06 08:10 PM

[Puritan:]

People must eat. Biggest country is China.
1 billion Chinese love pork.There are two
well established pork conglomerates:
HOGS and FEED making profits hand over
pigs feet.
2. People get sick. TEVA is making and selling
medicine all over the world at more affordable
cost.
3. Some innovative biotechs are begging to
be bought at these prices: ARNA and SGEN
are my favorites. CRXL is an oyster with
incredible vaccin power.

Puritan (71)

2008 Oct 06 11:13 PM

[bigtime99:]

Didn't Templeton tell us to buy at the point of maximum pessimism?

2008 Oct 07 12:29 AM