The market is holding together at high retracement levels for the S&P. Yields reflect a stable d...
The Dark Side of the BRICs
11/19/2009 1:50 pm EST
Emerging market stocks have been the stars of the global market rally, and the BRICs (Brazil, Russia, India, and China) have set the pace.
Since their lows in late October 2008—they bottomed a few months before we did—the MSCI Emerging Markets index has soared 116%, while the MSCI BRIC index has skyrocketed 150% (all measured in dollars).
That makes the Standard & Poor’s 500’s 65% gains from its March lows look like chump change.
In the past year, Brazil has been on fire, surging 139.5%. Russia and India are close behind, with advances of around 115%, and China is the “laggard,” with a mere 94.5% gain.
But how long can this go on? Isn’t a correction long overdue? I think so, and investors who have been piling in to these markets are going to get badly burned.
The rationale for the big move—and every rally has a plausible one—is that with big surpluses and strong economic growth, the BRICs and other emerging markets are coming into their own, while developed countries are still picking up the pieces from the recession and financial crisis.
That’s true, of course, but what’s even truer is that emerging markets have moved from being diversifiers to “intensifiers”—amplifying moves made by their stodgier cousins.
That also makes them more vulnerable to rare “black swan” events, which are triggered by things usually not on investors’ radar screens.
“Emerging market equities are developed market equities on steroids,” says Peter Stanyer, economist and strategist at Delmore Asset Management in London and author of Guide to Investment Strategy, whose new edition will be published in January.
Indeed, according to ING Investment Management, emerging markets have had a “beta” of 1.4x that of developed markets this decade, which means they’ve moved 40% more than, say, the S&P 500.
So, you can gain a lot more, but you can lose your shirt, too.
Those of us with long memories—going back, say, a couple of years—may remember how much these markets fell in the recent crash. While the S&P lost 57% of its value from top to bottom, China and Brazil shed around three-quarters of theirs.
“The correlation gets even higher and the benefits of international diversification become even less [in a downturn],” says Jay Ritter, professor of finance at the University of Florida.
So, emerging markets are more vulnerable to “black swan” events. That term, used by Nassim Nicholas Taleb in his 2007 book, refers to events so rare they don’t lie within the normal probability scale. Taleb argued that black swans are more common than investment professionals think, and investors need to protect themselves against them.
One professor, Javier Estrada of IESE Business School, says black swan events have a bigger impact on emerging markets. “The evidence, based on more than 110,000 daily returns from 16 emerging equity markets, is unequivocal: Outliers have a massive impact on long-term performance,” he writes.
In developed markets, he found, missing the best ten days caused investors’ portfolios to lose 51% of their value, while missing the worst ten days resulted in a 150% gain. But if you missed the best ten days in emerging markets, you were worth 69% less, whereas missing the worst ten days resulted in portfolios that were 337.1% more valuable.
So, how can you be out of the market on the worst days and in on the best? You can’t. “The odds against consistently successful market timing in emerging markets are staggering,” Professor Estrada concludes.
So, investors need to be especially aware of events that could knock markets for a loop.
Case in point: last year’s invasion of Georgia by Russia.
Russia’s market already had lost ground by August, when Russian tanks moved across the border with Georgia in response to disputes in South Ossetia. But after the invasion, the market collapsed, losing half its value in six weeks. Foreign investors panicked, triggering a massive run on the ruble.
But what about Brazil and India?
Brazil has been rightfully praised for its financial management—it long ago moved from debt to surplus—and its status as a world-class exporter of resources to markets like China. It also will become a major oil exporter in the next few years, and has a remarkably transparent stock exchange.
But beneath the glitter of coastal megalopolises like Rio de Janeiro and Sao Paulo, social dynamite is waiting to explode. Weeks after Rio was named the site of the 2016 Summer Olympics, drug gangs shot down a police helicopter in the middle of town. That parallels equally brazen moves a couple of years ago in Sao Paulo, the financial capital.
And in the New Yorker, writer Jon Lee Anderson traced the pervasive reach of these gangs in Rio’s slums (“favelas”).
“At least a hundred thousand people work for the drug gangs of Rio in a hierarchical structure that mimics the corporate world,” he writes. “The state is almost completely absent in the favelas. The drug gangs impose their own system of justice, law and order, and taxation—all by force of arms.”
Could Brazil go the way of Mexico, where violent gangs vie with the government for control? Who knows, but consider this from a former revolutionary who’s now part of Brazil’s government: “If [the gangs] ever acquired an ideology, they could threaten the state, he said.”
Like, for example, in India, where there's a serious insurgency led by Maoist guerillas, called Naxalites. They control huge swaths of territory in southeastern India, as the armed forces prepare a major offensive against them.
Will any of these flashpoints turn into wildfires? Who knows? And technically some of these markets aren’t terribly expensive. (Brazil trades at around 12x earnings, way below the S&P’s 18x multiple.)
But after such an amazing run, risk is growing. That’s why this would be a good time to take some money off the table here, too.
Howard R. Gold is executive editor of MoneyShow.com. The views expressed here are his own.
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