Why an Emerging Market Bubble May Be on the Horizon | Long Island, NY

Why an Emerging Market Bubble May Be on the Horizon

By: Steven M. Roge, CMFC

In recent years, emerging markets have attracted significant attention and capital, neither of which was undeserved. First, they gained attention because they provided unique investment opportunities in developing countries with tremendous growth potential, unlike “stodgy” options such as the United States and the United Kingdom. Second, with the advent and popularization of ETFs, investing in emerging markets was easier than it ever had been before, and large amounts of capital shifted to take advantage of these opportunities. However, we believe a reality check may be in order, and in the next few minutes we will walk you through our current thesis on emerging markets; but first, a capital markets refresher.

While we cannot predict returns or what will unfold in the near-term, we hold fast to two core beliefs that dictate our investment thesis:
Capital markets theory dictates that whenever there is arbitrage (or, in general, above-average investment opportunities) funds will flow toward this opportunity in order to make a profit, and
Since capital markets cannot predict values perfectly, history has shown many times that too much money will flow toward the opportunity until it is overvalued, creating an unsustainable bubble.
We have seen this pattern repeated time and time again. Within the past dozen years we have separately seen both technology companies and real estate become the “hot” sectors, only to become overvalued and subsequently crash. While each sector proved to be a good investment opportunity at the outset and attracted large amounts of capital (Belief 1), too much money flowed to these opportunities, creating a bubble (Belief 2). Based on the underlying tenets of capital market theory and what we have witnessed throughout history, we believe that there is another bubble lurking about on the verge of popping.
We see a bubble in emerging market equities. While we believe that the growth in emerging market investing was justified due to economic expansion opportunities and capital flow, higher commodity prices, and a weaker dollar, these once-promising markets may soon face headwinds from all three factors.
In explaining our case, we will provide evidence from our three key factors, which encouraged the historical growth and investment opportunities of emerging markets, but which now may lead to a collapse. It is also important to recognize that these three factors will not bring down the entire country, or even the bond markets; we are strictly focused on the collapse of emerging market equities.
The Case for Growth

Opportunities for economic expansion by emerging market countries is a great investment thesis—the United States, though not an emerging market, created unsurpassed wealth for its citizens during an incredibly long period of economic expansion from the 1940s through 2000, despite bumps along the road. After seeing the wealth that the US created, many investors would jump at the chance to get in on the ground floor of an emerging market in hopes that similar economic expansion and wealth creation could be realized.
Relative to our two other factors, economic expansion of emerging market countries has unfolded over a much longer time horizon, most notably over the past few decades. Both technology advances and the spread of capitalism have encouraged this growth through the sharing of ideas and technologies and increasing import/export markets. Technology in particular has made it cheaper and easier to start businesses across the globe, and small businesses often provide the backbone for many countries’ economies. Needless to say, as businesses and investment opportunities pop up and investors can communicate quickly across the globe, capital begins to migrate toward these investments.
In addition to general economic expansion, many emerging market countries have enjoyed strong growth because of their commodity-rich geography. Using the Dow Jones Emerging Market classifications, emerging markets include the oil-dependent countries such as United Arab Emirates, Qatar and Oman and mining countries such as Brazil, Peru and Argentina. Many of these emerging market countries are very dependent upon their global natural resource exports for continued economic growth, and thus are very sensitive to any price changes in the commodity. The oil countries have built up staggering wealth as both developed and emerging markets are voracious oil consumers and prices continue to be high.
While the dollar has bounced back and forth over the past few years relative to other global currencies, the underlying trend has been a weakening dollar with no fiscal or monetary policies to support a strengthening of the dollar. This is especially apparent with the Fed’s QE2 program, which essentially is just creating dollars out of thin air, further depressing the value of each dollar. The flipside to a declining dollar is that other currencies strengthen against the dollar, thus, returns on international investments can be even higher when converted back into dollars because the foreign currency is now stronger. Also, many global commodities (oil for example) are priced in the global marketplace in US currency, so as the dollar declines, oil prices increase, further helping those oil-rich emerging markets.
Needless to say, the opportunities for economic expansion of commodity-rich countries, compounded by a weakening dollar, has propelled many emerging markets to valuation levels that may no longer make sense as these three factors turn around.
The Case for Collapse
While emerging markets will still grow in the long-term, the world is still feeling the aftershocks of the recent financial crisis, decreasing growth and investment opportunities. In addition, natural disasters such as earthquakes, tsunamis and typhoons have left part of the world just trying to recover, let alone grow. The United States specifically, as one of the largest exporters of capital, still requires rock-bottom interest rates and dollar-printing machines to keep capital flowing
As investors chase these foreign opportunities, it is possible that some emerging markets have become overvalued relative to mature markets. For example, consider the current value of the iShares MSCI EAFE Index ETF (EFA) relative to its emerging market counterpart, the iShares MSCI Emerging Market Index (EEM). EFA holds securities from countries such as the UK, Japan, Germany and France; only ten countries make up nearly 90% of the index, with a combined GDP of nearly $20 trillion. Similarly, the EEM fund invests approximately 90% of its assets in ten countries such as China, Brazil, Taiwan and Russia, with a combined GDP of only $12.5 trillion. However, both funds each have roughly $40 billion under management, implying that investors are overweighting emerging markets significantly relative to mature markets.
Anther piece of evidence pointing to an overflow of capital to the emerging markets is the fact that the Vanguard Emerging Markets Stock Index ETF (VWO) was the most popular index fund in the United States in 2010, attracting more than $19 billion in capital, making the SPDR Gold Trust ETF (GLD) a distant second as it pulled in less than $6 billion . In an even more disparate comparison than the iShares example above, VWO manages over $65 billion to invest in emerging markets, while Vanguard’s EAFE ETF (VEA) manages less than $9 billion.
While previously we discussed how natural resources helped the emerging markets prosper, a downturn in commodity prices can equally harm these markets. This wouldn’t be so alarming if commodity prices were not so high right now, but unfortunately they now have a long way to fall if the tide turns. One of the biggest commodities most investors watch is oil, which is currently hovering around $100. Nearly all investors remember the time when oil spiked a few years ago to over $140, only to come crashing down to the $30s. Similarly, oil reached an inflation-adjusted average of above $100 in 1980 , and fell below $30 (inflation-adjusted) within 6 years.
The sharp rise in oil prices, especially relative to the anemic global economic growth, should be cause for concern. Since bottoming out in 2009, oil is up more than 150%, which is obviously unsustainable. Many other commodities important to emerging markets have increased extraordinarily as well, and when we hear reports than speculators artificially add $10 or more to a barrel of oil, we can assume the same is happening with other commodities. Simply removing the speculators and letting supply/demand take its course may bring commodities down to more reasonable levels, thus dampening returns for many emerging markets.
Finally, commodities should decrease against the strengthening of the US Dollar. As we discussed before, commodities priced in USD benefit as the dollar falls; however, they can just as easily be harmed by a strong dollar. Compounding this effect, a strong US Dollar would decrease returns made on foreign investments, thus making foreign markets (both developed and emerging) less attractive than domestic investments. While we have yet to see any direct information on how the government plans to support the dollar, we may see an effect from the completion of the QE2 program. By slowing the flow of dollars, we hope to see a stronger dollar emerge.
While a strong dollar would hurt all foreign investments, the double-whammy of weaker commodity prices and a stronger dollar would most likely hurt the emerging markets worse due to their relative lack of currency strength. If these events begin to unfold, investors who have piled right into emerging market funds in staggering numbers may just as quickly head for the exits. Emerging market funds have certainly enjoyed an admirable run, but it may be time to think about rebalancing your portfolio to underweight these markets— that way, when things do go wrong, you will be among the few who avoid hearing the sound of a bubble popping in your portfolio.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This discussion is for informational purposes and should not be taken as a recommendation to purchase any individual securities. Information within this discussion and investment determination of the author may change due to changes in investment strategy when warranted by changing market conditions, or if a security’s underlying fundamentals or valuation measures change. There is no guarantee that, should market conditions repeat, this security will perform in the same way in the future. There is no guarantee that the opinions expressed herein will be valid beyond the date of this presentation. There can be no assurance that the author will continue to hold this position in companies described herein, and may change any of his position at any time.We use or best efforts to obtain good data in our models, however it can’t be guaranteed that our inputs and data are correct. This is not a recommendation for readers to purchase shares in the above security without consulting your financial professional to discuss your own risk tolerance and objectives.

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