It wasn’t all that long ago when most investors would build a portfolio out with the majority of it allocated in domestic stocks. This “home bias” seems odd though since if you’re truly an investor that is using your eyes to gauge opportunity, you would buy international stocks. U.S. stocks currently represent less than 49% of the world market. As a consumer of products and services just look around and think about all of your favorites. (car, electronics, appliances, toys, furniture, clothing, etc.) Where in the world are they made? We’ve all been educated on the merits of investing overseas by now…right? Not necessarily! The average American investor still has about 90% of their holdings devoted to U.S. companies.
How about we peel the onion one more layer? Of the relatively small percentage of investors that typically hold International stocks even less is allocated towards Emerging Markets. Most people perceive international stocks to carry more risk than domestic stocks (currency risk, political/regulatory risk, transaction risk, and increased volatility) All of this would theoretically be amplified when dealing with even smaller countries in lesser developed regions. Ironically enough, risk is actually lowered when adding international exposure.
Studies show that adding about 25% of your equity exposure towards International actually delivers a higher portfolio return with lower risk (standard deviation) than just holding U.S. stocks alone. Investing in International or Emerging Market stocks has higher stand-alone risk but adding it to a well-built portfolio enhances your diversification and potentially lowers your overall risk. Taking diversification one final step further can be done with “Frontier Markets” which are even smaller, have greater political and economic instability and higher risk-reward ratios. You’ll find that frontier markets have much more volatility than developed or emerging markets but also tend to have better long-term returns.
Emerging Markets are getting hammered this year and if there is one guarantee it’s that you will see more and more headlines to that effect. Watch for some emotionally impactful headlines and stories; they’re already appearing but we believe there is much more to come! The main drags on Emerging Markets this year are due to the four key countries that drive some of these headlines; the BRIC countries (Brazil, Russia, India, and China). Each is respectively down YTD about -22%, -12%, -15%, and -11%)
Investors are running for the exit doors at a rapid clip. Just this past June alone we saw $9 billion of outflow from International ETFs (Exchange Traded Funds). The leading stinker of the bunch was Emerging Markets ETF’s with over $4.4 billion in outflows! Is the herd usually right or do they typically make emotional knee jerk reactions? We believe it’s the latter this time and although there will be more headwinds, increasing exposure to Emerging Markets is not just about being a “Contrarian”.
A “contrarian” employs an investing style that goes against the market trends. He or she is likely to buy when an investment is performing poorly and sell when it’s doing well. There are many variations to this approach. Some investors might simply call themselves “value” investors as they search for mispriced assets or investments that appear overly punished and therefore undervalued by the market. Other types of contrarians sometimes lean on simple behavioral finance and just take the opposite stance of whatever holds most investors’ attention.
Even though Emerging Markets (EM) are down big time relative to U.S. stocks this year (-10.25% for EM versus +19% for the S&P 500), we believe once sentiment changes there could be dramatic outperformance over domestic stocks. These markets have clearly underperformed but are showing signs of stabilizing while the U.S. stock market is long overdue a correction. Our markets have clearly surprised most and it’s not a stretch to think that the market is far ahead of what is realistically an anemic economy being propped up by a lot of help from the Federal Reserve.
It’s difficult to find investments that aren’t related to others in some manner. Our worlds are more and more interconnected. What we’re insinuating here is the hunt for lower correlations. If you have enjoyed the record-breaking run in the domestic stock market why not take some profits off the table? Markets don’t go up in straight lines forever. Eventually they’ll have to take a breather and once they do you will cherish whatever you own that is not directly correlated to domestic equities. Lately we’re seeing signs of an asset class that has begun to show more and more clear signals of an almost inverse correlation and that could bode well for alert investors.
For so many investing in Emerging Markets has been a play on commodities. If China hiccups the commodity driven world wants to implode. Hasn’t some of the slower growth story in China been overdone? Don’t be the last one to read about it! In our opinion that story is pretty well baked into current market pricing. Mr. Market will always have a few more surprises up his sleeve but don’t expect it to be a “fresh” story about China’s economy slowing down. Valuations on several Emerging Market countries are easily trading at 10-year lows! The investment pendulum always tends to swing too far to one side and then it creates investor capitulation. We might not be there quite yet but it’s getting awfully close…
In summation we believe that over the next year or so it’s very likely that Emerging and some Frontier Markets will outperform the U.S. stock market. Not only should you consider having some exposure to these high growth markets but this could be an excellent time to make an allocation adjustment to a new investment environment that won’t necessarily play out as it has in the past. The best investors look for opportunities in front of them and don’t focus on the rearview mirror.
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