Surviving Bloody Monday In Emerging Markets

October 07, 2008

CIOs say stock carnage points to importance of diligently managing risk and keeping hype touting maturity of developing markets in perspective.

After the bloody sell-off on Monday, the MSCI Emerging Markets Index is now trading at more than a 46% loss for the year.

But not everyone's running for cover. "If anything, we're leaning towards accumulating more emerging markets stocks if prices keep falling," said Jack Payne, chief investment officer at JoycePayne Partners. "Demographically, emerging markets is where most of the incremental world growth is going to take place. This correction might slow the momentum in that direction, but it won't stop it forever."

Another CIO, Roger Nusbaum, recently started buying selected stocks as well as shares of the exchange-traded fund BLDRS Emerging Markets 50 ADR Index (NasdaqGM: ADRE).

"This type of behavior—panic with no fundamental logic—doesn't make sense rationally. But it's something we see over and over in the history of stock markets," said the Phoenix-based CIO at Your Source Financial.

"If you believe a market isn't permanently broken and its price breaks in half, that's a good time to ask whether the time is ripe to reenter that market," added Nusbaum, who recently moved back into emerging markets after some leading indexes had fallen 60% or more from their peak levels a few years ago.

The 50-stock ADRE dropped 7.4% on Monday alone and is down more than 38% this year. With 335 different names, the iShares MSCI Emerging Markets Index Fund (NYSEArca: EEM) lost nearly the same both on the day and so far in 2008. Another popular diversified fund, the 885-name Vanguard Emerging Markets ETF (NYSEArca: VWO), fell 8.5% on the day and has slipped more than 40% on the year.

BRIC's Role 

So what's new about the latest fallout? China and India led emerging markets' earlier stumbles. Those are two of the so-called BRIC nations that are expected to grow the most over the next 20 years—Brazil, Russia, India and China.

"Now, with the decline in commodities and raw materials prices, the other BRICs have finally started to fall just as hard," said Richard Shaw, president of QVM Group.

In the past 10 trading days entering Monday, Russian stocks had fallen almost 45% and Brazil some 35%. Heading into this week, the iShares MSCI Brazil Index ETF (NYSEArca: EWZ) was down better than 40% on the year. And losses in the Market Vectors Russia ETF (NYSEArca: RSX) had topped 50% in 2008. Both fell in low double digits on Monday.

"There's zero rational behavior going on in the markets right now, so there's certainly justification to cut back a little," said Gary Gordon, president of Pacific Park Financial in Aliso Viejo, Calif. "But it's a little late in the game to bail out completely. Picking a bottom in emerging markets isn't something we'd advise at this point."

Emerging markets are inherently riskier than developed international waters. But many investors have ignored history's lessons, says Nusbaum.

That's not too hard to imagine considering that EEM, the most popular ETF of its kind with $17.2 billion in assets, soared to 30%-plus returns for three straight years beginning in 2005.

"The justification for putting more money into emerging markets has been that somehow they're not going to feel a slowdown in the U.S. as much as they have in the past. But that's turning out to not be correct," said Nusbaum, referring to fundamental views that developing markets had matured to a point where previous boom-and-bust cycles wouldn't be as acute.

 

In fact, some of the same ardent supporters of emerging markets are arguing that now's a good buying opportunity. They point to declining price-earnings ratios. It's true that some leading emerging markets stocks that were once trading around 19 times trailing earnings in some cases are valued at half those levels now.  

"It's certainly an opportune time looking strictly at fundamental valuations," said Shaw, who oversees portfolios for his Glastonbury, Conn.-based firm's institutional and high net worth clients. "But when people are afraid like they are now, they don't care about PE ratios and price-to-book values. The vast majority of investors are just trying to avoid a train wreck."

Even those who are willing to listen to such estimates, he adds, aren't as willing to drink the emerging markets Kool-Aid after years of overhype. "Nobody really knows what the impact of the credit crisis will be on PEs and earnings over the next several quarters," Shaw said. "Conditions are changing so rapidly right now, there's just no confidence in the fundamentals right now."

His own investments are heavily in cash. But he has been scaling back gradually. Shaw adds that he plans to keep holding existing emerging markets funds already in his portfolio.

Routine Maintenance 

Nusbaum is doing much the same after Monday's pummeling. "Anyone who has been investing in emerging markets over the past several years has seen those values go up at a faster rate than the rest of their portfolio," he said. "Scaling back as part of routine maintenance of a diversified portfolio should've already taken place."

Portfolio manager Payne agrees. But he says that investors need to take a close look at what they own when buying emerging markets ETFs. He points out that EEM's largest position, for example, is Russian natural gas giant Gazprom. Its second-biggest name is consumer electronics maker Samsung, followed by Taiwan Semiconductor.

"Energy, Basic Materials and Tech account for nearly 60% of EEM's portfolio," Payne said. "Most emerging markets indexes are driven by highly cyclical sectors. They typically have very little exposure to more defensive sectors like Health Care and Consumer Staples."

But that lack of diversification is a major reason why Payne isn't recommending investors walk away from emerging markets anytime soon. Instead, he's looking to complement his broad-based emerging markets ETFs with niche developed markets funds. Those include: the iShares S&P Global Healthcare Sector Index Fund (NYSEArca: IXJ); the iShares S&P Global Industrials Sector Index Fund (NYSEArca: EXI) and the S&P Global Consumer Staples Sector Index Fund (NYSEArca: KXI).

"The middle class is still just forming in most of the countries. As a more affluent class develops, so will sectors such as Health care and big-ticket goods and services," Payne said. "Over the next decade or two, we expect emerging markets to diversify and compare much more favorably to developed markets. But we're still a long way away from reaching that point."


Murray Coleman is managing editor of IndexUniverse.com. He can be reached at: [email protected].

 

 

 

 

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