Despite a summer of bad economic news from many emerging economies, such troubles have not been reflected in their stock markets: since bottoming on 24 June, the MSCI Emerging Markets Index has returned 13.2%, outperforming developed markets by 3%. A pattern appears to be emerging, with emerging market equities appreciating ahead of earnings and macroeconomic growth. The takeaway? Investors who wait too long risk missing out.
History shows that investors should buy on pessimism
Emerging markets are younger and more volatile, with higher dispersion of returns and greater cyclicality. Optimism thus rises as earnings and profitability improve and declines as they fall. At market peaks, emerging market equities appear to be low risk with high return on equity (ROE) and strong earnings growth. At market troughs, the reverse is true.
Troughs in valuations and earnings expectations provide a strong buy signal
Given the volatility, investors should be cautious and look to reduce exposure to emerging market equities as valuations reach historic peaks, while adding exposure as valuations approach market troughs.
Conclusion: Don’t wait too long
ROE has fallen, earnings continue to disappoint, pessimism is entrenched, and valuations remain low. Can valuations go lower? Can currencies fall below fair value? Yes, but a cyclical asset class with high volatility is a buy in these circumstances for investors with a one-to three-year horizon and a sell for those with a three- to six-month time horizon.