Exploiting Boom-to-Bust Cycles in Emerging Markets

Emerging market stocks are highly prone to recurring bubble-like cycles caused by economic and currency volatility and erratic “hot money” flows. As I discussed last week (link), recent experience over the past five years indicates that this high degree of volatility very much continues to be a defining characteristic of emerging market equities. If anything, with rising debt levels and newly forming markets in the frontier world such as Vietnam, everything points to more volatility in the future.

The chart below from a recent article from value investors GMO Asset Management (Link) shows the incredible economic volatility suffered by emerging markets compared to the S&P 500. Focusing on the grey bar of the chart, which represents the three worst performing EM markets, the chart shows the probability of declining earnings per share for any given year.  For the 1995-2017 period,  there was a 30% probability for the bottom three EM countries to have EPS growth of -50%. Given the very high correlation between EPS growth and market returns, this, in essence, means that an investor can expect about one 50% plus drawdown (market correction) for at least one country in the emerging markets universe in any given year.

 

 

The chart below confirms this with data on 46 market drawdowns of over 50% since 1990. This period of 28 years covers pretty much the entire period of institutional investor participation in emerging markets. Therefore, on average  1.7 specific country drawdowns of over 50%  occur every year. Since 2015, seven such drawdowns have occurred, right in sync with the trend of the past 28 years.

The huge price corrections that emerging markets consistently experience raises the question of whether these markets are suited for the buy-and-hold passive investor. Nevertheless, almost all of the flows invested in EM today are participating through passive indexed instruments like ETFs, and the majority of active investors also tend to track the indices closely, so that most investors are subjected to these violent drawdowns.

On the other hand, the active investor with a systematic methodology for avoiding drawdowns stands to have a very significant advantage in these markets, following a few basic rules:

  1. Focus on countries having recently experienced severe drawdowns, and which are valued significantly below long-term average multiples of cyclically-adjusted earnings.
  2. Identify a turning point; usually a political change or economic reforms which trigger recovery.
  3. Increase positions as a positive trend develops.
  4. Increase caution as markets gain momentum and valuations reach levels well above long-term averages.

Fed Watch:

  • Trade and Globalization in EM (Voxdev)
  • Gavekal view on the cycle, China, commodities and EM (CMG Wealth)

India Watch:

  • Ray Dalio is bullish on India (IB Times)
  • The strategic importance of India’s rise (CSIS)
  • Walmart prepares bid for Flipkart (Bloomberg)
  • India’s demographic dividend (Livemint)
  • Modi’s make-in-India strategy (NYT)
  • Infosys to sacrifice margins for growth (Bloomberg)

China Watch:

  • Starbuck’s has a new competitor in China (WIC)
  • The craft beer war in China (supchina)
  • Police nab bandit at concert using facial recognition tech (WIC)
  • China plays it cool (Mauldin)
  • Brookfield is bullish on China real estate (Forbes)
  • Trump’s weak case against China (Project Syndicate)
  • Anbang’s political connections worked until they didn’t (Caixing)

China Technology Watch:

  • DJI is shaking up China private equity (WIC)
  • China installed 10 GW of solar in Q1 (Tech Review)
  • China to double-down on chip development (Reuters)
  • Didi launches in Mexico (Recode)

Technolgy Watch

  • Taiwan is falling behind Korea (SCMP)

EM Investor Watch

Investor Watch: