3 Reasons to be Bullish on Emerging Markets

10/04/2012 9:15 am EST

Focus: STOCKS

As emerging market stocks hit 11-day highs on Tuesday, Chris Ciovacco, contributor, SafeHaven, details his reasons for continued optimism.

When the next rally in risk surfaces, it could produce impressive gains in Asia (AAXJ), China (FXI), India (INP), and emerging markets (EEM) based on:

  1. Indian reforms to attract foreign capital
  2. On-going liquidity injections in China
  3. Improving technicals

Stocks Need to Overtake Bonds Again

Prior to adding to our risk exposure, we would like to see some improvement in several risk-on/risk-off ratios. The three risk-on vs. risk-off ratios below can assist in monitoring the health of the current rally.

The chart below tracks the performance of stocks (SPY) relative to bonds (AGG). When risk is in favor, the ratio rises. When defensive assets rule the day, the ratio falls. Four weeks ago risk-on broke the "neckline" of a potentially bullish inverted head-and-shoulders pattern (see chart below). In the last three weeks, risk-off has been in favor bringing into question the bullish breakout for risk. Should more weakness in stocks follow, the ratio has potential support above the green arrow. Until the chart below recaptures the neckline, we will tread carefully with our cash.

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Another risk-on/risk-off ratio (S&P 500/TLT) had a "head fake" Monday. Stocks have completed two of the three steps needed for a bullish trend change. The ratio recently broke the blue trendline (see 1 below). Step 2 was a higher low (see slope of green line). The third step would come if the ratio can make a higher high above the green dotted line. Early in the session on Monday, the ratio was well above the green line. However, the bears started buying Treasuries as the day progressed, which erased the bullish breakout for risk. We will be more open to investing some additional cash if step 3 can be completed in the coming days.

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NEXT PAGE: Shorts Gaining Ground On Longs

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Shorts Gaining Ground On Longs

The current rally in risk assets remains intact, but a few more days of weakness could push our market models into correction mode. The chart below illustrates the fragile nature of the bulls' reign. When the ratio below is rising, short-sellers (a.k.a. bears) are making more money than traditional investors (longs or bulls). If the ratio breaks above the green-dotted line, it will have (1) broken a trendline, (2) made a higher low, and (3) traced out a higher high. Those are the three steps needed for a trend change, and thus would signal increasing bearish momentum. Bulls would like to see the Relative Strength Index (RSI) remain below 50; it closed Monday at 48. Should the chart below clear the green line, we would be more apt to sit on our cash in the short-term vs. adding to our emerging markets exposure.

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Indian Reforms to Attract Investors

Policymakers in India are concerned about slowing foreign investment. According to a September 23 Forbes story, some concrete reforms may be coming to address the situation:

The Economic Times reported Monday that New Delhi is getting ready to push for capital markets changes in order to attract overseas capital. For instance, just last week the government said it would allow foreign companies to acquire majority stakes in India retail. The latest steps under consideration include raising the ceiling for foreign borrowing, easing restrictions on portfolio investors, and liberalizing norms for overseas borrowings.

From a technical perspective, the news from New Delhi helped India (PIN) gain traction relative to the S&P 500 (chart below). The break above the downward-sloping blue trendlines is supported by the bullish divergence in a popular indicator, known as MACD (blue bars in chart below). A divergence occurs when price makes a lower low (red line) and an indicator makes a higher low (green line). The divergence can be seen by comparing the slopes of the red and green lines.

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Bases Tend to Mean Lower Risk

It is prudent for investors to fear "buying near a top". If risk assets peak, global stocks will suffer, but the degree of losses can be mitigated if we avoid "straight up" markets. The chart below shows the performance of India (PIN) relative to the S&P 500. The sideways price action is known as a base (see green box). The upper portion of the box and blue lines acted as resistance for five months; they may now act as support.

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NEXT PAGE: China Joins Liquidity Party

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China Joins Liquidity Party

If you can fog a mirror, you have heard about money printing from the Fed and ECB once or twice in the last few months. Central banks are injecting money directly into the financial system. According to the Economic Times, China has started to print as well:

SHANGHAI: China's central bank injected a net 365 billion yuan ($57.92 billion) into money markets this week, traders said, the largest weekly injection in history, as regulators struggle to maintain liquidity without producing inflation as forex inflows slow.

As shown in the chart below (FXI/S&P 500), China has been lagging the S&P 500 in 2012. The green arrow shows the recent liquidity injection may enable FXI to break the current downtrend.

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Asia Breaks Out

The Asia Ex-Japan ETF (AAXJ) responded to the liquidity injections from China's central bank. The chart below shows the performance of AAXJ relative to the S&P 500. The chart has a bullish look with several trendline breaks, a healthy RSI (bottom), and a big base below.

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Asia's breakout was foreshadowed by the bullish divergence between price and MACD (compare slopes of lines A and B). The longer the chart below can stay above the green line the better.

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Asia vs. Bonds Not Bad Either

We have shown AAXJ making progress relative to the S&P 500. How does it look relative to bonds? The answer is "good." The weekly chart below shows the strength of AAXJ relative to bonds (AGG). When the ratio is rising, AAXJ is gaining ground on AGG. The recent push in the ratio above the blue trendlines is a potentially bullish signal for Asian stocks.

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In order to increase our exposure to the emerging markets space, we need to see stocks pick up steam relative to bonds. Should the risk-on vs. risk-off charts shown above improve, then we will be looking primarily at EEM, AAXJ, and INP. However, bullish traction remains tentative and should be monitored with an open mind.

by Chris Ciovacco, Contributor, SafeHaven

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