Note: This article appears on the ETFtrends.com Strategist Channel
By Carl Noble
Most investors are aware that Emerging Markets have badly underperformed in the current cycle. While the S&P 500 has spent the better part of the past six years continually pushing to new highs, Emerging Markets have largely spun sideways before breaking lower over the past year. In fact, the magnitude of the differential has been striking—since reaching a relative peak all the way back in 2010, Emerging Markets have underperformed the U.S. by more than 120% (measured using EEM vs. SPY) and other developed international markets by nearly 40% (EEM vs. EFA).
But recently, Emerging Markets finally showed some signs of life—after falling to the lowest level since 2009 on January 20th, Emerging Markets rallied nearly 25% through their recent high on April 19, handily outpacing developed markets. This move coincided with a sizable rebound in commodity prices that were boosted by growing calls that the ‘low’ is in for oil, leading some investors to pile back into reflation trades. Indeed, Emerging Markets ETFs have received inflows of nearly $2 billion this year, after three years of outflows totaling almost $12 billion, according to data from Bloomberg.
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However, the latest move may already be fizzling out, as Emerging Markets have dropped by almost 10% since the April high. Looking back over the past 6 years, this isn’t the first time that Emerging Markets have had a powerful counter-trend move—by our count, there have been seven rallies of 10% or more versus the S&P 500 since peaking in 2010, lasting on average about 9 weeks.
While these rallies seemed powerful and alluring at the time, all of them ultimately failed, disappointing those who thought that the final lows for Emerging Markets were in. From a charting perspective, the relative strength ratio has consistently traded below the 40-week moving average since 2010, with the rallies either only marginally exceeding or turning lower at that average (see chart).
Granted, such a long period of underperformance does mean that they appear to be significantly undervalued relative to U.S. stocks now, with a forward P/E of only 11.5 on the MSCI Emerging Markets Index compared to 16.8 for the S&P 500, but that has generally been the case for the past several years and it hasn’t prevented Emerging Markets from continuing to lag. Part of the problem stems from the fact that many Emerging Markets indexes carry heavy weightings in Financials and resource-related stocks that have been decimated by the commodity rout, making them appear cheaper than they really are. In other words, they may represent a value trap.
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In our view, the latest move appears to be another head fake in the ongoing long-term relative downtrend, suggesting that it still makes sense to steer clear of Emerging Markets. Significant macro headwinds remain in the form of the ongoing slowdown in China, low commodity prices (despite the recent rebound), and cautious consumers in Western countries. Investors who are looking for overseas diversification may be better served by sticking with developed markets for the time being, where aggressive monetary policy support may provide a helpful tailwind for risky assets in those markets.