Stocktake: Are emerging markets the trade of the decade?

Are emerging markets the trade of the decade? Emerging markets are stuck in bear market territory and have endured years of underperformance, but they might be the trade of the next decade.

So says influential California outfit Research Affiliates, one of many voices to recently turn bullish on emerging markets (EMs). Citigroup, Goldman Sachs, BlackRock and UBS have all warmed to EM of late, although Research Affiliates' glowing recommendation was the one that dominated the headlines last week.

EMs now trade on a cyclically adjusted price-earnings (Cape) ratio of just 10, it says, below 96 per cent of readings over the last 25 years. During that period, EMs’ Cape has dipped below 10 on only six occasions; five years later, they had soared 188 per cent.

Some caution is warranted. First, Research Affiliates does not actually foresee another quick tripling in prices, instead estimating annual returns of 7.9 per cent over the next decade.

Second, Morningstar cautions that the MSCI Emerging Markets Index’s trailing price-earnings ratio has been “fairly range-bound” since 2008; indeed, EM equities have traded well below today’s multiple on several occasions in recent years.

Finally, cheap can always get cheaper; EMs look a decent long-term bet, but patience may be required. Short selling on the rise Short sellers tend to be a savvy bunch. Should investors be worried, then, that short interest in the New York Stock Exchange (NYSE) recently hit 18 billion shares – near the high reached in July 2008, just before Lehman Brothers collapsed and all hell broke loose?

Certainly, anyone holding a stock targeted by shorts would do well to consider whether the sceptics might be right; a basket of the most shorted stocks has declined in price by 38 per cent since early 2014, Bespoke Investment Group said last week, compared with a gain of 4 per cent for the least shorted stocks.

Overall short interest is less alarming than appears, however. Yes, it is rising – Bespoke notes four out of 10 S&P 1500 sectors have seen more shorting than at any time in at least 52 weeks – but the 2008 analogy is inappropriate.

Short interest as a percentage of the float for the S&P 1500 has gradually risen to 6.5 per cent over the last year, compared with almost 12 per cent in autumn 2008, when market alarm catalysed an enormous spike in shorting.

The recent data will not encourage bulls, but talk that shorts foresee another market collapse is wildly overstating matters. Volatility suggests low returns The S&P plunged almost 7 per cent in the first half of February but the recent snapback rally erased those losses.

Far from indicating that the storm has passed, however, recent market action suggests investors should be prepared for continued volatility.

Michael Batnick of Ritholtz Asset Management found 43 previous examples where stocks suffered an early- month plunge only to finish positive for the month, and his findings are not encouraging.

The average one-, three-, six- and 12-month returns are all negative.

A year later, stocks were higher less than half of the time.

The good news is that when stocks did gain, they gained big – about double that seen in a normal year.

In short, don't unfasten your seatbelt any time soon. Running out of ammo Many commentators are warning that 2016 will see further equity market declines on the basis that central banks are finally out of ammunition.

They may be right, but it's worth remembering this is not a new argument, as Wealth of Common Sense blogger Ben Carlson noted last week.

Headlines from the mainstream media over the last seven years include: "Rate-hikers at the Fed are running out of ammo" (2015); "Why the Fed has no ammo left" (2014); "Federal Reserve: What happens when the Fed really does run out of ammo?" (2013); "Fed running out of ammo" (2012); "DeKaser says Fed 'running out of ammo' for economy" (2011); "The Fed running low on ammo" (2010); and "Running low on ammo" (2009).

Carlson’s collection of headlines inspired me to check if I had used the word “ammunition” myself.

Sure enough, one end-of-year summary noted that “commentators were warning that the Federal Reserve, having already slashed interest rates to rock bottom levels, had run out of ammunition.”

That was in 2010.

Monetary and macroeconomic conjecture makes for interesting theatre, as Carlson puts it, but basing your investment plans around it is another matter entirely.