Emerging market ETFs have taken a beating over the last couple of months in every way imaginable. The iShares Emerging Markets Index Fund (EEM) dropped over 18% from a 3 Month high of 44.27 on May 8th to a low of 36.16 at the beginning of last week. It wasn’t just equities getting slammed, though. Spreads for sovereign bonds of emerging market nations over US Treasuries climbed as the developing countries’ debt got sold off too, with the WisdomTree Emerging Markets Local Debt Fund (ELD) dropping over 15% in the same period. As money flowed out, so the currencies declined; the Mexican Peso, for example, fell around 11% against the US Dollar during that time.
Last week saw some relief as the equity and bond ETFs seemed to have found a bottom. In my mind, however, this may be a pause before selling resumes, but this could set up a decent level to buy into emerging market equities.
The above 5 year chart shows that EEM bounced off of a previous support level at around 35.00, but it also puts the recovery in perspective; it’s that little green uptick at the end. Last week’s price increases represented about a 30% retracement of the drop, but as we approach the magic Fibonacci 38.2% level, I expect renewed selling and a break through that 35.00 support.
When the Fed started, then doubled down on QE, there was much talk of them creating a bubble in equities, but most commentators focused on the US market. I don’t believe that happened and have said before that, even given recent volatility, US equities still have room to the upside. If there was a bubble, it is beginning to look like we could have been looking in the wrong place for it.
As more money was pumped into the system and Treasury rates were depressed by the bond buying program, the market’s need for a return, and therefore appetite for risk, grew. What better home for risk seeking money than the notoriously volatile emerging markets? For a while, it seemed to be a one way bet. The first signs of trouble began to emerge around the middle of last year, when it became apparent the the Chinese economy couldn’t continue growing exponentially forever.
In the time honored style of frothy markets there was a correction, but demand returned quickly and those warnings were ignored. When the Fed began to talk of “tapering” QE and interest rates began to rise, the sell off started. It was fast and sustained. Some buying at previous support levels was to be expected but as the major financial institutions come to terms with an end to the flood of money, high risk areas will continue to be under pressure.
The outlook, then, for EEM and other emerging market ETFs such as VWO and SCHE looks bleak in the near future. A drop to another 5 or 10 per cent below the lows of a week ago looks likely. When you consider the fundamental picture rather than the technical one, however, any such drop will be a good buying opportunity.
The fact is that while the price action makes these ETFs look a little bubbly, the valuations don’t. Taken as a group, emerging market stocks are trading at around 10x trailing earnings, significantly less than those of developed nations, and while forecasts for growth in the EM economies are being cut, it is the rate of growth that is slowing. They are still expected to grow.
For those who like to invest with the style of a trader, this scenario presents an interesting opportunity. Using EEM as an example, you could sell now at 38.50 with an order to buy twice as much just above the next support following a break of 35, say at 31.00. If it works out, you would be owning EEM at an average of around 23.50, levels not seen since the depths of the financial crisis. A stop at around 42 would limit losses should the rally continue, making for a trade with a decent risk/reward ratio.
This trade is not for everyone, as there is still a significant amount of risk involved in selling EEM at a time when it seems to be bouncing back. If, like me, though, you think this bounce will be short lived, it may provide an opportunity to gain exposure to emerging market stocks at levels many thought would never be seen again.