With the tremendous volatility markets have experienced over the past few months, I am often asked for my thoughts on where equities will go next. In truth, I am still bearish given the still strong deflationary message the bond markets are signaling independent of expectations of further quantitative easing, or QE3, from the Federal Reserve.
However, I do think that if one wanted to position into equities, it might be worth considering that on a relative basis emerging markets, and in particular China, may give the most outperformance potential in the near term.
Take a look below at the price ratio of the iShares FTSE China 25 Index Fund (NYSEArca: FXI) relative to the SPDR Dow Jones Industrial Average ETF (NYSEArca: DIA). As a reminder, a rising price ratio means the numerator/FXI is outperforming (up more/down less) the denominator/DIA.
There are a few things I’d like to point out here. First, while the ratio bottomed in late October 2008 and powerfully outperformed the U.S. in the early part of 2009, the great economic powerhouse topped out all the way back in July of 2009, underperforming the Dow for the next two years.
The ratio appears to be bottoming out now, and could be on the verge of a strong outperformance move. Note that this ratio can still trend higher even in a bear market – it just means that China may go down less or even up slightly in a declining equity environment, depending on the magnitude of the outperformance.
The question to always ask yourself when looking at price ratio charts is “does leadership appear justified?” To me the answer is likely yes.
Consider that should QE3 be implemented, funds likely will flow out of the U.S. and into emerging markets such as China. In addition, the longer something lags, the more likely it is to lead for some period of time. There is a decent cushion priced into China now relative to the U.S.
I’ve also seen a lot of data showing that funds have flown out of the China ETF in a big big way all year long. This alone makes the outperformance argument very real if one takes a contrarian standpoint.
Full disclosure: The author, Pension Partners, LLC, and/or its clients may hold positions in securities mentioned in this article at time of writing. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.