Filed under: Weekly Market Commentary

Is EM Washed Out?

John Lynch Chief Investment Strategist, LPL Financial

Written by Boone Wealth Advisors

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Are emerging markets (EM) washed out? Last week the MSCI Emerging Markets Index officially sank 20% from its peak in late January. This prompted many bearish headlines, such as “Emerging Markets Slide into Bear Market amid Contagion Concern,” and “It’s Beginning to Look a Lot Like a Crisis.” At the same time, a recent survey from Bank of American/Merrill Lynch showed that global fund managers are underweight EM equities for the first time in more than a year. One thing is for sure: From a contrarian point of view, the level of pessimism we are seeing toward EM could potentially be a bullish sign.

After highlighting here some of the fundamental reasons we remain optimistic on EM equities despite recent weakness, we’ll take a look at EM sentiment this week to try to answer the question: Is EM washed out?

HOW NORMAL IS EM VOLATILITY?

How common are big EM pullbacks? As Figure 1 shows, when it comes to EM, it can be quite normal. Going back 15 years, the MSCI Emerging Markets Index pulled back at least 15% (intra-year peak to trough) 11 times. In six of those years, the index finished the year higher. EM could not dig itself out of a big hole after heavy losses in 2014 and 2015, and ended those years in the red. However, those periods were marked earnings recessions—nothing like the solid fundamental backdrop we are seeing today.

A POSITIVE TECHNICAL SIGNAL?

EM is clearly exhibiting negative technical momentum, as the EM Index has broken below its 50-day and 200-day moving averages—and those averages are downward sloping. Momentum is only one way to employ technical analysis (not to mention the fact that there are many different flavors of momentum), and relative strength analysis of EM versus the S&P 500 Index may not give you a complete picture. However, we can look at the price ratios of other assets for additional insight on emerging-market stocks’ future path.

The price relationship between gold and silver stands out to us right now. The gold-to-silver ratio measures how many ounces of silver it takes to buy a single ounce of gold. The spread was above 85 recently, which was the highest since late 2008, when the financial crisis began.

As Figure 2 shows, the previous three times the gold-to-silver ratio was near 80, the MSCI EM Index was near a low. Additionally, the EM Index is near a major trend line of potential support. Only time will tell if this scenario plays out again, but it’s worth watching as a potential bullish signal for EM and a possible rotation into riskier assets.

OTHER GAUGES OF SENTIMENT

Here are some other factors to consider when gauging sentiment in EM:

Significant U.S.-EM divergence. EM has not diverged this much from the U.S. stock market since the mid-1990s. While this gap could close if U.S. stocks drop, we expect it to be resolved through EM gains.

Weak breadth nearing a contrarian signal. About 35% of stocks in the MSCI EM Index are below their 200-day moving averages, not far from the 20% level where EM has typically bottomed out (as was the case in early 2016).

Low valuations. Simply put, we think a lot of bad news is priced into EM stocks, especially given the mostly favorable economic backdrop and positive earnings growth outlook.

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Written by Boone Wealth Advisors

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