Learning to Love Volatility in Emerging Markets

Though economic and currency volatility may reduce the long-term sustainable GDP growth of countries like Brazil ( Brazil’s Economic Stagnation), paradoxically,  volatility is also the primary source of returns for the emerging markets investor. Economic booms, with rising stock markets and strengthening currencies, are invariably followed by busts, with collapsing markets and weaker currencies. For the investor who measures returns in dollar terms, the more volatile emerging markets provide turbo-charged results both on the way up and the way down. Learning to love that volatility is often the key to success.

Brazil is one stock market that is marked by enormous swings. Since 1990 Brazil has seen three market collapses; -88% in 1997, -76% in 2008, and -88% in 2011 (all measured in USD terms). Brazil also had a 80% collapse in the seventies and an 88% drawdown concluding in 1990. It seems that about once a decade, a period that should be well within a reasonable time horizon for most investors,  an investor in Brazil suffers  losses of between 80-90% in terms of U.S. dollars.. But Brazil is far from being unique in emerging markets in this regard. Since 1990, there have been 41 cases of a stock markets losing more than 50% of their value, with an average drawdown of 72%. Over this period, Turkey and Argentina are the champs, each experiencing six drawdowns of over 50%.

On the positive side, drawdowns are followed by bull markets, like day follows night. Over the next two and half years following the 41 market bottoms, investor see average returns of over 500%. Every Brazilian collapse has been followed by a extraordinary bull market:

  • 1983 bottom (-80%), followed by 14x return of capital
  • 1991 bottom (-87%), followed by 24x return of capital
  • 2002 bottom (-83%), followed by 17x return of capital

For the value investor, the brutality and frequency of emerging market drawdowns creates a dilemma. Value investors, indoctrinated by Warren Buffett’s consistent wisdom, believe in investing for the long-term. For example, two commonly cited quotes from Buffett are:

“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 year;”

And “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.”

An emerging markets investor could follow Buffet’s advice, patiently sitting through the drawdowns. By sticking with only the highest quality companies, the drawdowns can be minimized. The astute investor can also improve returns by trimming positions when valuations are high and taking advantage of market meltdowns to add to positions.

However, an alternative and often more productive better way to invest in emerging markets is to learn to love the volatility and skillfully harness it as the major source of returns.  Emerging markets, like commodities, often experience extreme cyclicality with predictable patterns. Investors that are aware of the patterns, can exploit them repeatedly. As commodity markets investor Martin Katusa says, investors in markets characterized by extreme cyclicality can best be “be approached with a ‘rent, don’t own” mentality.”

A strategy which may be anathema to value investors but is very effective in emerging markets and commodity investing is to marry a valuation process with basic trend-following techniques. An investor can patiently wait for a market to meltdown and then watch like a hawk for an entry point to ride the inevitable bounce-back. Typically, good entry points are created when a market has reached extraordinarily low valuations and is showing signs of trending up. Market bottom valuations, in my view, are often signaled by cyclically adjusted price/earnings ratios (like the CAPE Schiller ratio), which should be dollarized to fully measure the volatility of the markets. Timing decisions can be influenced by simple trend-following indicators, like the 50-day or 200-day moving average.

The advantage of patiently waiting for markets to bounce back before deploying capital is that the investor does not experience massive losses of capital on the downside. The absolute investor without concern for benchmarks is in a better position to do this than most institutional investors who are not willing or permitted to stray from their benchmarks for long periods of time.

Us Fed watch:

Brazil Watch :

  • China’s Fosun looking at Brazil Healthcare (SCMP)
  • IMF On Latin America Currency Flexibility ( IMF)

Mexico Watch:

  • WEF Tourism Competitiveness Report shows Mexico’s Rise (WEFORUM)
  • Mexico’s surprising oil finds (NY Times)

India Watch:

China Watch:

  • Mark Mobius on China  (Templeton)
  • Beijing’s New Airport (Caixing)
  • Xi Jinping’s War on Financial Crocodiles (FT)

China Technology Watch:

  • Chinese train maker expands U.S. market  (China Daily) 
  • China Launches new generation bullet train (WIC)
  • Beijing Subway Blocks ApplePay WIC
  • JD.COM invests in drone delivery (China Daily)
  • China plans $108 BB investments in chips (WSJ)

China Consumer Watch:

  • China’s Hisense wins sponsorship for FIFA 2018 (China Daily)
  • China rises in global tourism competitiveness (China Daily)

Korea Watch:

Eastern Europe Watch:

  • Poland is breaking out of the Middle-Income Trap (NY Times)

Commodity Watch:

  • Oil’s Game of Chicken; Can OPEC Finally Bankrupt U.S. Production (Seeking Alpha)

Anti-Globalization Watch:

Emerging Markets Investor Watch:

Guru Watch:

  • An Interview with Peter Bernstein (Jason Zweig)
  • Chano’s sees weak U.S. economy (Inetenomics)Notable Charts:
  • China Inverted yield Curve signals slowdown
  • Commodities at record low valuations relative to the S&P 500

Notable Quotes:

  • When markets finally do break, as they always have historically, ETFs and index funds will be destabilizing influences, because fear will enter the marketplace. A higher percentage of assets will be in indexed funds and ETFs. Investors will hit the “sell” button. All you have to ask is two words, “To whom?” To whom do I sell? Index funds and ETFs don’t carry any cash reserves. The active managers have been diminished in size, and most of them aren’t carrying high levels of liquidity for fear of business risk.” (Bob Rodriguez – We are witnessing the development of a “perfect storm”(seeking alpha)

“Stock prices are likely to be among the prices that are relatively vulnerable to purely social movements because there is no accepted theory by which to understand the worth of stocks….investors have no model or at best a very incomplete model of behavior of prices, dividend, or earnings, of speculative assets.” (Robert Schiller)