Monday, July 13, 2009

Emerging Markets - Highway to the Danger Zone!

Bloomberg wrote a pretty fair and accurate article on the over-valuation of emerging markets. I didn’t trim this article as I found the entire piece to be interesting. Note the references to IMF and also World Bank growth forecasts. I’m not sure the game that’s being played here, but now when I see a piece that largely tells the over-valued truth I get suspicious as to the motive. Is it time? Are the central bankers positioned correctly for this article to play?

I know, but you must have a skeptical mind for these markets, things are NOT what they appear on the surface.

Here’s a two year chart of the Emerging Market Index to keep in mind while reading this article:

Emerging Markets Priciest Since 2007 When Shares Fell

By Adria Cimino and Michael Patterson

July 13 (Bloomberg) -- The last time stocks in developing countries got this expensive was in October 2007, just before the MSCI Emerging Markets Index began a 12-month tumble that erased half its value.

The MSCI gauge trades at 15.4 times reported earnings, compared with 14 for the Standard & Poor’s 500 Index, according to weekly data compiled by Bloomberg. When developing nations last commanded a premium, the 22-country benchmark sank 54 percent in the next year.

Groupama Asset Management, Palatine Asset Management and Standard Life Investments say the disparity means investors are paying too much for shares from China to India to Brazil at a time when the global economy is contracting. MSCI’s emerging- market gauge is valued at 1.7 times its companies’ net assets after a 34 percent surge last quarter, the highest on record compared with the MSCI World Index of 23 advanced economies, which trades for 1.5 times, data compiled by Bloomberg show.

“Emerging-market stocks are at risk,” said Matthieu Giuliani, a Paris-based fund manager at Palatine, which oversees $5.56 billion. “You should only pay so much for growth.”

Investors are already starting to show a lack of confidence in a continued rally. The MSCI developing-nation index dropped 8.3 percent from its 2009 high on June 1 through last week, while the MSCI World fell 7.4 percent and the S&P 500 retreated 6.8 percent. Emerging-market funds had $540 million of net outflows in the week to July 8, the second time in three weeks investors withdrew money, according to Cambridge, Massachusetts-based EPFR Global, which tracks funds with $10 trillion worldwide.

Volatile Returns

The MSCI emerging-market index declined 2.4 percent to 718.72 as of 8:36 a.m. in London, the steepest intraday slump since June 23. The MSCI World slid 0.6 percent, while futures on the S&P 500 lost 0.5 percent.

All 22 emerging-market currencies tracked by Bloomberg depreciated against the yen in the past month, and 16 weakened against the dollar. The yen usually attracts investors during economic turmoil because Japan’s trade surplus makes the nation less reliant on overseas lenders, while the dollar benefits from its status as the world’s reserve currency.

While developing nations’ economies grew an average 1.7 times faster than developed countries in the past 20 years, their stocks traded at a discount because their economies and returns were more volatile. Brazil’s annual inflation averaged more than 1,000 percent in the 1990s, and South Korea required a $57 billion bailout from the International Monetary Fund during the Asian financial crisis of 1997.

Bull Markets

The MSCI emerging-market index had 13 bull-market rallies of at least 20 percent and 12 bear-market declines of the same magnitude since its inception in December 1987, according to data compiled by Birinyi Associates Inc., the Westport, Connecticut-based research and money management firm founded by Laszlo Birinyi. That compares with five bull markets and four bear markets for the S&P 500 during the same period.

Developing nations led the worldwide rally in equities last quarter, with China’s Shanghai Composite Index adding 25 percent and India’s Bombay Stock Exchange Sensitive Index jumping 49 percent. The gains outpaced a 20 percent rise in the MSCI World and a 15 percent advance in the S&P 500.

The increase cut the dividend yield of the emerging-market gauge to 2.97 percent, compared with 3.49 percent for developed countries. MSCI’s emerging-market index fetches 1.1 times sales and 6.7 times cash flow, compared with 0.8 and 4.3 in the advanced gauge, data compiled by Bloomberg show.

Record Share

“Gains came too quickly in the context of a slow economic rebound,” said Romain Boscher, who helps oversee $119 billion as a director at Groupama in Paris. “Valuations are now high, and that leaves the door open for a drop. Emerging and developed markets are at risk.”

Developing nations’ share of global equity value climbed to an all-time high this month as investors poured in a record $26.5 billion last quarter, according to data compiled by Bloomberg and EPFR.

The infusion helped Beijing-based oil producer PetroChina Co. climb 17 percent in Hong Kong trading this year and overtake Exxon Mobil Corp. as the world’s largest company by market capitalization. PetroChina’s shares are valued at 11.3 times earnings, compared with 8.9 for Irving, Texas-based Exxon.

PetroChina, which traded at a discount to Exxon as recently as April, is one of five Chinese companies ranked among the world’s 10 biggest by market value. The rest are in the U.S.

Growth Premium

Itau Unibanco Holding SA in Sao Paulo, Latin America’s largest bank by market value, trades at 2.7 times net assets, more than double the 1.1 price-to-book ratio for Banco Santander SA. The Santander, Spain-based lender got 33 percent of its net income from Latin America in the first quarter and is the world’s 10th-biggest financial company by market value.

For Carmignac Gestion’s Eric Le Coz, emerging-market equities deserve a premium because the economies are the only ones projected to grow this year. Financial institutions in developing nations also avoided most of the credit freeze that caused almost $1.5 trillion of writedowns and credit losses since 2007, according to Bloomberg data.

Le Coz’s firm is buying shares of Beijing-based China Construction Bank Corp., which trades for 2.5 times book value, and Bharat Heavy Electricals Ltd., the New Delhi-based manufacturer of power-plant equipment that’s valued at 31 times earnings.

Not as Fragile

The Washington-based IMF estimates developing economies will grow 1.5 percent as a group this year and 4.7 percent in 2010, while advanced economies will contract 3.8 percent in 2009 and expand 0.6 percent next year.

Emerging markets “should be more expensive,” said Le Coz, who helps oversee $28 billion as a member of the investment committee at Carmignac in Paris. “In the past, emerging markets were fragile. Today that’s not the case.”

Brazil, which defaulted on its foreign debt twice since 1983 and devalued its currency in 1999, now has an investment- grade credit rating from S&P and Fitch Ratings. Moody’s Investors Service said this month it may upgrade Latin America’s biggest economy.

China surpassed Germany in 2007 to become the world’s third-largest economy. Russia has $409 billion of foreign exchange reserves and India has $253 billion, the world’s third- and fifth-biggest holdings, according to Bloomberg data.

‘Grave’ Prospects

Developing nations traded at a discount to American equities from 2001 to 2006 even after their economies expanded at almost three times the pace, according to Bloomberg and IMF data. They moved to a premium in October 2007, the peak of a five-year advance that sent the MSCI gauge up fivefold. The index’s drop in 2008 was almost 16 percentage points steeper than the S&P 500’s 38 percent slide, the worst since 1937.

When emerging-market valuations climbed above the U.S. in 1999 and 2000, it foreshadowed the end of a seven-year global rally. The MSCI developing-nation index sank 37 percent in the 12 months after March 2000, compared with a 23 percent slide in the S&P 500.

The Washington-based World Bank spurred a worldwide sell- off last month after warning of “increasingly grave economic prospects” for developing nations and predicting the global economy will contract 2.9 percent this year, compared with a previous forecast of a 1.7 percent decline.

Equities sank on July 2 as the U.S. government said the economy lost 467,000 jobs last month, 102,000 more than the median economist’s estimate.

‘Run Too Far’

Emerging markets “are still dependent on exports and the health of wealthy countries,” Palatine’s Giuliani said. The European Union was the biggest export market for Brazil, Russia, India and China as of 2007, the last period the data were available, according to the Geneva-based World Trade Organization. The U.S. was the second-biggest market for Brazil, India and China.

Shares in developing nations are the most vulnerable to further declines because prices “have run too far ahead” of a recovery in profits, according to Standard Life’s Jason Hepner.

Companies in the MSCI emerging-markets index that reported results since the end of the first quarter posted an average earnings drop of 92 percent, trailing analysts’ estimates by 14 percent, according to Bloomberg data. That compares with a 46 percent profit slide for Europe’s Dow Jones Stoxx 600 Index and a 31 percent fall for the S&P 500, Bloomberg data show.

“We favor the more defensive markets like the U.S.,” said Hepner, an Edinburgh-based money manager at Standard Life, which oversees about $178 billion worldwide and has a “very light” position in emerging-market equities.

While BlackRock Inc.’s Bob Doll projects developing-market equities will be the most attractive stock investments over the next few years, he says they may lead a short-term retreat as investors reduce expectations for an economic recovery.

“A lot of risk assets are ahead of themselves,” said Doll, vice chairman and chief investment officer of global equities at New York-based BlackRock, which had $1.3 trillion under management as of March 31. “Almost always, what goes up the most, pulls back the most.”

Indeed! I agree that a lot of risk assets are ahead of themselves, but agreeing with a public statement made by someone running BlackRock makes me nervous.

I do think that it’s interesting that some of the developing nations banks are in relatively better condition. Those parts of the world that didn’t participate in the securitization/ “derivatization” of everything above ground have been and will probably continue to be relatively better off.

Still, they are dependent upon demand from the rest of the world, so expecting fundamental REAL growth is probably not the brightest call at this juncture – doesn’t mean that speculative “hot” money can’t run these markets higher.

Below is the Point & Figure chart for the Emerging Market Index. Note the very bullish target of 63! I highly doubt this index will reach that height with this fundamental backdrop. However, betting against them now might be a little dangerous, especially with BlackRock making comments like that!

Another thing that gives me pause about this chart is that I see the “dragon” pattern here. I won’t try to draw it, but imagine the tail on the left, two feet, a long neck and a head… when the head is above the “back” it is a bullish formation as it is here. So, if you go back to the chart at the top of this article, you will see that formation there too. Note also that it retraced half of its enormous decline and then fell back to the 38.2% retrace line where it is finding support now. To me it looks like it may fall back to the 23.6 which places prices at the top of the “dragon’s back.”

Overall I think emerging markets are over valued. But I also think playing these markets in either direction is playing in the danger zone.