Playing Indonesian Stocks In A U.S. Bear Market

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Includes: EIDO, IDX, IDXJ, IF
by: Owen Williams, CFA

Summary

Indonesia's economic slowdown is tapering and recovery will be predicated on Chinese growth.

The Jakarta Composite Index suffered a full cyclical Bear Market last year, showing its decorrelation with the U.S. markets.

We will continue to be buyers of Indonesian stocks whenever our models permit.

The Indonesian economy has been one of Asia's gems since the beginning of the century. The fourth largest nation is the world succeeded in defeating the problems of high inflation and high cost of capital while asserting its role as supplier of Chinese growth. Indonesia has extensive natural resources, including crude oil, natural gas, tin, copper, and gold, giving the country a strong export sector and role in fueling growth in the region. Importantly, Indonesia continues to enjoy high growth, with GDP averaging between 5% to 6% since the 2000.

Indonesia has recently hit a soft path in the in the past couple years due to China's waning appetite for coal and other commodities waned, and the U.S Federal Reserves' threats of increased borrowing costs. We would describe the slowdown in Indonesia as a "soft landing", as GDP slow to 4.96% in June of last year from 6.49% be in June of 2010. GDP has bounced back to 5.04% last quarter. Retail sales are healthy (+11.9% y/y), export growth picked up to its highest level in over a year this February, and the manufacturing sector has likely bottomed for this cycle (PMI rose to 48.7 in February from 46.4 last year, showing a slowing of the contraction). Prospects are also encouraging for trade going forward, with Indonesia's participation in the Trans-Pacific Partnership (TPP).

Finally Indonesia stands out from many developed nations, including the U.S., in running a trade surplus and a low debt-to-GDP ratio of around 20%, and enjoying energy independence. These factors, along with a strong growth rate, argue for a strong Indonesia rupiah (see below).

Indonesia's Stock Market

In terms of Indonesia's stock market, the benchmark Jakarta Composite Index (NYSE:JCI) has reflected the country's high growth and resource-rich economy. The JCI is up +1,313% since 2001 and up +340% since the Financial Crisis of 2008. In addition, the Indonesian stock market shows significant decorrelation with Western Exchanges (correlation coefficient of 0.33 with the S&P 500 since 2000, for example). To this end, the JCI began correcting in early 2015, before developed markets fell out of bed. The JCI suffered a full cyclical bear market (-24%) last year, but has bounced back in 2016 to become on the best stock markets thus far this year, up +5%.

How We Are Playing Indonesia

We remain optimistic on the Indonesian stock market going forward. We moved into Indonesia (NYSEARCA:EIDO) (NYSEARCA:IDX) in January based on our models and are enjoyed double digit gains due also to the positive currency effect. When playing Indonesia as a U.S. dollar or euro-based investor, attention to the underlying currency effect is the key to success. The following two charts summarize our constructive outlook on the Indonesian rupiah (IDR). Since the Asian Crisis in 1997, the IDR has been well-behaved gyrating most of the time between 8,000 to 11,000 rupiahs per U.S. dollar. The exceptions have been during the Financial Crisis and today. We don't feel the IDR should fundamentally be trading anywhere close to Asia Crisis levels (1997). The red line in the middle of the trading zone from the 1997 Crisis, and well represents fair-value for the IDR, we feel.

The next chart charts that since our last parameterized weekly MACD sell signal in 2011 (a rising curve is IDR weakness) the rupiah has depreciated by almost -70%!!! This fully reflects China's slowdown and prospects of higher U.S. rates and we believe offers an exciting opportunity to buy a high-growth, long-term holding at a very cheap level.

This does not mean investors should buy Indonesia stocks and close their eyes. Last Monday we reduced our position on Indonesia in our DGR Strategy. As many readers may be interested in profiting from this strategy, we will use this trade to help explain the strategy algo. The DGR Strategy uses signals off our Sector Allocation Model both to adjust allocation weightings and generate new position ideas. We have been long S.E. Asian stocks in the strategy since January, as the SA Model allowed us to build positions in Thailand, Malaysia and Indonesia (we had been bullish on these stock markets last year, but needed the green light from the SA Model to move in). These positions have helped drive returns this year. Last Monday, 21 March, we received a red "Reduce" on the Weekly Indicator for the Jakarta Composite Index, as shown in the print of the SA Model below:

We therefore cut the 10% EIDO (iShares Indonesia) position to 5% (realizing a +17.54% profit on the 5%). We did not close the position as the Monthly Indicator has remained on a green "Accumulate" (in addition to the fact that we remain constructive on this asset class). If the trend changes and the Monthly Indicator turns red, we will not be dogmatic and will close out the Indonesia position to stay in line with the Model and not try to "out-guess" the market.

Next, let's look at WHERE the SA Model pulled us out of Indonesia. March 21 is indicated in the Jakarta Composite Index chart below. Yes, the SA Model pulled us out of Indonesia at the cycle high. HOW? The SA Model inputs consist of two vectors (the market price in the chart AND our WMA in-house price using a dynamic ratio of the index price to our Multi-Asset Index level). By cointegrating these vectors and analyzing the second derivative of the curves (the rates of change of the slopes), we obtain many timely signals like this each quarter. This is, if you will, the "secret" to the success of the strategy.

Conclusion

We continue to recommend play Indonesia from the long side. Whenever our models permit it, we will be buyers of EIDO or IDX in 2016.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.