Tiptoeing Back into Emerging Markets

03/24/2009 12:08 pm EST

Focus: GLOBAL

Carlton Delfeld

Editor, The La Jolla Letter and Pacific Gains

Carlton Delfeld, editor of the Chartwell Global ETF Letter, outlines a strategy to invest in emerging markets with a little risk protection.

iShares MSCI Emerging Markets (NYSEArca: EEM) is a contrarian pick since the current headwinds facing emerging market economies are formidable as reflected in its share price.

As an example, Malaysia’s dependence on exports, commodities, and manufacturing tells me that it may be one of the first countries to recover with a global economic recovery. The service sector of Malaysia accounts for only 55% of its GDP. It also is highly dependent on exports, with 75% of these exports manufactured goods.

It may surprise you to learn that emerging markets have actually weathered the financial storm better than the US and Europe [this year]. Until the recent market rally, emerging markets were down about 10% in 2009 versus negative 22% for the Standard & Poor’s 500 index.

Part of this is due to the strong Shanghai market and positive performance by Chile and Brazil. A key issue for EEM is whether China is able to hold GDP growth to its 7% to 8% target.

Economists and investors around the world have been puzzling over whether China can escape the worst of the global slowdown. Exports have been a pillar of China’s impressive economic rise in the last three decades, and the sharp drop in February compared with a year ago was unexpected.

But investment spending strengthened. The National Bureau of Statistics said that fixed-asset investment, which has played a bigger role than exports in China’s growth, had climbed 26.5% in the first two months of 2009 compared with the first two months of last year.

That growth was larger than expected and marginally higher than its average for all of last year. But the averages concealed a significant shift in what is being built in China, as the government moved to replace crumbling real estate. For example, railroad investment spending more than tripled in the first two months of the year. Meanwhile, construction of office buildings, factories, and apartments, [which] had been rising more than 30% a year, was flat as a pancake.

Using EEM as the foundation of your emerging market allocation makes sense: It offers a pretty good distribution between China, Brazil, India, Russia, South Korea, and South Africa, [with] smaller allocations to other emerging market countries.

Emerging market countries have outperformed developed markets, and investors who initially sold off these perceived higher-risk markets will likely return cautiously and incrementally.

The risk factor is high, and I suggest an 8% trailing stop loss. A smart move may be to couple EEM exposure with a put option (right to sell) on EEM. This will give you some downside protection. These options are available as far out as January 2011. (EEM closed above $26 Monday—Editor.)

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