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So we've got that emerging market dip--now what do we do with it?
12/03/2010 8:30 am EST
A lot of investors have watched this year as emerging stock markets have left their portfolios in the dust.
From May 20 through November 5, the Brazilian stock market (measured by the gains on the iShares MSCI Brazil ETF (EWZ)) was up 38.5%.
The Indian stock market, measured by the BSE Sensex 30 index, was up 28.2% from May 26 through November 5.
The Chinese stock market, measured by the Shanghai SE A share index, was up 33.6% from July 5 through November 8.
If only, many of us wished, these markets would dip so we could get in.
Well, since those November highs and through November 30, the Brazilian market was down 7.8%, the Indian market 7.1%, and the Shanghai market down 12.1%.
And suddenly all those investors who were clamoring to buy at ever rising prices are pulling money out of markets that are decidedly cheaper than they were just three weeks ago. In India, for example, foreign investors have taken $158 million out of the markets since November 12.
That’s quite a reversal from the $5 billion that these investors put into Indian financial markets in the first 12 days of the month.
On November 30 I wrote a piece arguing that in the short run—the next few weeks or months or maybe even a quarter or two—the U.S. stock market is likely to be the best performing market in the world because 1) the U.S. economy is likely to deliver the best performance in the world, and 2) the world’s other stock markets and economies show huge near-term problems. In that time period I think you want to own U.S. stocks and in that post I mentioned nine possible buys to enjoy short-term U.S. relative advantage. (See my post http://jubakpicks.com/2010/11/30/the-u-s-is-the-champion-stock-market-in-the-world-at-the-moment-although-its-reign-is-likely-to-be-rather-short/ )
But what about the longer run? However, you define longer-term, I think that emerging market stocks or developed economy stocks with big emerging economy exposure will out perform stocks from the world’s developed economies. Everything from
- Demographics: the emerging economies are younger and don’t face (for a couple of decades anyway) the big drag of rising healthcare and retirement costs from a quickly aging population
- Economic growth rates: China is growing at 10%, India at 8%, Brazil at 7%. The United States would sell the Mall of America for 3% growth. The European Union will be lucky to see 2%. Japan?
- Fiscal balances: The United States, Spain, Ireland, the United Kingdom, France, Japan are all facing huge budget deficits and debt overhangs that threaten their credit ratings and that will raise the cost of capital for those countries. The emerging economies are going in the other direction with improving credit ratings and falling interest rates in the long-run.
So instead of running for the hills because Shanghai is going through one of its frequent corrections or because business scandals have put the Mumbai stock market into reverse, investors ought to be using this dip as a chance to add emerging market exposure to their portfolios.
Just a few little questions to answer first.
When? At what price? and What?
There are two ways to go about answering the “When?” question.
The first involves making a reasonable estimate for how long the current troubles sending emerging markets stocks lower will last.
So, for example, you can estimate that a good part of India’s dip will be over when the current wave of business scandals passes. The biggest of these, the 2G scandal, has led to resignation of India’s telecommunications minister over charges that some of India’s biggest wireless operators got more spectrum than they had paid for. Market shaking scandals with life spans of even three months are rare.
India’s other problems—over-valuation in the stock market (Sensex stocks sell for 18.8 times reported earnings, a big premium to Brazil’s Bovespa at 13 times), inflation that will require more interest rate increases from the Reserve Bank of India, and a big balance of payments gap—will take longer to work out, but I’d guess-timate that you’d probably want to be back in the Indian market by mid-2011.
Brazil’s problems seem both limited to a few months and maybe extended for six months or so. In the short run, I think the financial markets are currently testing President-elect Dilma Rousseff to see if she is committed to fighting inflation and to reducing (or at worst holding steady) the size of Brazil’s public sector workforce. The judgment on that will be in by March or so. In the longer run Brazil’s big challenge is actually getting inflation under control without stomping on the brake so hard that it kills economic growth. We should be able to judge the efforts of the Banco Central do Brasil on this front by June.
The big dog among emerging markets is, as always, China. It is possible for an emerging stock market to go up when China’s stocks are going down or nowhere—see the performance of India’s Sensex index at several points this year—but it’s not easy. The best guarantee for a rally in emerging market stocks remains an end to the worries that ended the impressive July to November rally in the Shanghai market.
What are those worries? And what’s a reasonable time table for putting them to bed?
Inflation and its close relative asset-price bubble are the major worries. Growth in bank lending and in the money supply remain out of control and that’s feeding into inflation that climbed to 4.4% in October and is projected to move up to 4.8% in November. Raising bank reserve requirements, on the record so far, seems unable to get the job done and price controls, perhaps the Beijing government’s preferred next step, will only attack the most visible surface details.
To really fix the problem China would have to allow its currency to appreciate a lot faster than the 3% to 5% most economists now expect for 2010 and raise interest rates repeatedly. The current interest rate on savings was raised in October to 2.5% by the People’s Bank. With inflation running at 4.4%, savers lose almost 2% annually on their money. To stop pushing cash in speculative assets, China’s central bank would have to raise interest rates on savings by 2 to four full percentage points.
Ain’t gonna happen. The kind of appreciation in the yuan and the kind of increase in interest rates required to do a Paul Volcker on inflation is out of the question until the underlying dynamics of China’s economy are much more seriously out of whack. Countries don’t adopt radically different economic policies until pursuit of the current policy has resulted in disaster. Remember that while Volcker crush inflation in the United States in the early 1980s, the Federal Reserve, which he had headed since August 1979 didn’t move decisively until inflation was running at a double digit rate. Inflation peaked at 13.5% in 1981 after Volcker’s Fed raise the federal funds rate from 11.2% in 1979 to 20% in June 1981.
I think instead of actual financial reform in China, what we’re looking at is a series of conventional measures that are just enough to make it look like the problem has gone away. My time table for those steps? Say the next six or seven months. (See my post http://jubakpicks.com/2010/11/23/can-beijing-fix-its-run-way-bank-lending-problem-does-it-really-want-to/ )
What does this timeline mean for you, the individual investor?
I’d say that it will give you a six month window of volatility for building positions in what you’ve indentified as your key emerging market stocks. During that period, emerging markets will go up and down with a 10% to 20% correction here and a 10% to 20% rally there but the net change during those six months is likely to be about zip, zilch, zero. (Remember Jim’s Rule of Two: a correction in a developed market is a drop of 10% a correction in an emerging market is a drop of 20%. Same with rallies.)
Obviously, you’d like to buy nearer the bottom than the top in any of those corrections/rallies. Which brings me to my second question, At what price?
Here I think charts can be a huge help. Let me use one of my favorite developed market ways to invest in emerging economies, Spain’s Banco Santander (STD), as an example. The stock has certainly had its up and downs in the last year. In the sell off just before the Greek “rescue” the shares traded to a low just below $9. In the sell off just before the Irish “rescue” (and in the continuation of that sell off when the markets decided not to put much faith in that “rescue”) the shares traded to a low just below $10.)
The volatility of the market this year gives you a sense, not of the fundamental value of the stock—that’s not what you’re looking for here—but the extreme lows where you can buy that fundamental value. Over the next six months as emerging markets—and emerging market dependent stocks such as Banco Santander—revisit their highs and lows repeatedly, investors will be able to build up a very solid picture of the extreme lows to which investor emotion will drive stocks.
You’ll get a good sense from this of what price to look for before you buy. So, for example, I’d love to catch shares of Banco Santander at the low near $8.77 (the June low) but I’d be fine buying at $9.62 (the November 30 low.) And at anything near those two lows.
What if you miss the best price, the lowest low? Don’t sweat it. One big upside in emerging market (or emerging market dependent) volatility is that the move off the low is often so strong that getting the lowest possible price isn’t as important as owning the stock when it rallies. A day after setting that $9.62 low, shares of Banco Santander tacked on a 7.8% gain. You’d like to capture a gain like that rather than still be sitting on the sidelines waiting for the drop to $8.77, the June low.
And that leads me to my third question What stocks?
Here’s where fundamentals do count. You like to be buying stocks of companies that are creating fundamental long-term value rather than just hoping to hit a stock that will bounce.
The reason that I’m even tracking Banco Santander is that I think the bank, as the strongest bank in Latin America as a whole, is positioned to profit from the growth in the economies of that continent and the increasing use of bank and credit products by a growing middle class. On the fundamentals, I’d set a one year target price for these shares at $20. (Whether the shares get there in that time period depends on whether stock markets are pricing in fundamentals or fear at that point in time.)
What other stocks would I be looking to accumulate during the six month window of emerging market volatility that I’ve outlined above?
Banks are one of the best ways to own a share of the growth of domestic consumer economies. Three I like are Banco Bradesco (BBD) and Itau Unibanco (ITUB) in Brazil and HDFC Bank (HDB) in India. (For more on Banco Bradesco see my post http://jubakpicks.com/2010/11/17/buy-banco-bradesco-bbd/#more-5861 )
Finding direct plays on the growth of mass consumer economies is harder since emerging market consumer companies are nowhere nearly as well represented in the world of ADRs and developed-market listed shares as raw materials companies are. China’s Home Inns and Hotel Management (HMIN), however, is a way to gain a stake in China’s growing internal travel market and the stock has developed a chart with lows as $41.50 and $44.80 that are worth watching. Brazilian airline Gol (GOL) set an intriguing low of $12.40 back in August that I’m watching. China’s giant Internet search company Baidu (BIDU) never seems to drop much but with six months of volatility ahead, investors can hope for a chance to pick up the shares on a deeper than usual dip.
Raw materials and commodity stocks have the potential to be extremely volatile as markets vacillate between the optimism of China will grow and the pessimism of China won’t grow. Gold, silver, and copper miner Compania de Minas Buenaventura (BVN), the largest publicly traded company in Peru offers the kind of volatility (a low of $35.96 in August and a high of $55.92 in November that promises investors a chance to get in on a commodity play in one of Latin America’s fastest growing economies at the low price sometime in the next month. If you’d like somewhat less volatility with plenty of upside consider Brazilian iron ore miner Vale (VALE). The October low of $27.27 is in easy reach for shares of South African platinum miner Impala Platinum (IMPUY) but I’d keep my eye on the July and August lows below $24 a share.
And just in case the investment gods are listening. Yes, I’m wishing for volatility in emerging market stocks. But I’m not wishing for too much volatility. Dips and corrections of 10% to 20% are just fine thanks. And a clear transition from this volatility to a rally in about six or seven months, please.
If that’s not too much to ask.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. As of the end of the September quarter, the fund owned shares of Banco Bradesco, Banco Santander, Itau Unibanco, and Vale. For a full list of the stocks in the fund as of the end of the most recent quarter see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/ )
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