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Get Ready to Buy Ugly, Cheap Emerging Markets

If, as the Wall Street adage goes, the time to buy is when blood runs in the streets, then investors should prepare, sadly, to start picking up emerging-markets stocks.

Even before the sometimes-violent anti-government unrest in Brazil, Turkey, Indonesia and Egypt began playing out on cable news, and a bank-funding crisis shook China, investors were souring on emerging markets.

After more than a decade of blistering economic development pulled in an outsized share of the world’s capital — thanks to China’s export-and-building boom and natural-resource riches surging from South America to Russia — the gears in the EM growth machine started to get stripped.

Commodity prices have been falling (although crude oil on Wednesday shot above $100 amid the crisis in Egypt). Central-bank money creation has fed inflation in emerging economies rather than developed ones, catalyzing mass protests in Brazil and elsewhere. Inflation – along with weakening currencies that make it harder for emerging countries to service their heavy debts – is preventing local central banks from cutting rates to promote growth.

China’s interbank funding market threatened to seize up last month and the fate of China’s credit binging economy appears precarious. On Wednesday Asian markets were hit following data out of China showing weakness in its services sector; Hong Kong's Hang Seng Index dropped 2.5% following the report.

Corporate earnings in Latin America and emerging Asia have sagged with global trade volumes, and capital has been pouring out of the developing world, mostly to the benefit of U.S. financial markets.

Punished markets

The markets have been punished as world investors have absorbed these vexing trends. The broad iShares MSCI Emerging Markets Index (EEM) exchange-traded fund is down 14.6% year to date, a gaping 25 percentage points worse than the Standard & Poor’s 500 index gain. Worse, the bellwether ETFs for China’s mainland stock market, the iShares FTSE China 25 Index Fund (FXI), and Brazil, the iShares MSCI Brazil Capped Index (EWZ), have lost about 23% each.

The carnage has presented a grueling test for even the most faithful emerging-markets boosters. Goldman Sachs (GS), the firm that helped coalesce the emerging-markets-ascendant theme a decade ago with its BRICs rubric (for Brazil, Russia, India and China), on Tuesday told clients to ditch an eight-month-old recommendation to bet on stocks with heavy BRIC exposure and against those without it.

When once-avid bulls capitulate and abandon a market, it can mean prices have gone a long way toward discounting the well-known bad news and are not far from bottoming.
This inflection point is only apparent in retrospect, of course. And some professional investors who have been correct in betting on the U.S. and against emerging markets are not ready to change their stance.

Richard Bernstein of Richard Bernstein Advisors, and a sub-advisor to the Eaton Vance Richard Bernstein Equity Strategy fund (ERBAX), has lately reiterated his negative stance on the sector, noting that a majority of companies there have been missing profit forecasts, a sign that analysts have not yet come to terms with the growth struggle there.

At some point, though, stocks become so cheap that most of the risk has been wrung out of them, promising better-than-average returns over the coming years. The emerging markets, broadly speaking, are trading around 10-times depressed 2013 profit estimates, a 30% discount to U.S. equities – wider than the average discount since 2005, but not as cheap as they’ve ever been.

Michael Hartnett, strategist at Bank of America Merrill Lynch, this week predicted “contrarian trading rallies” in natural-resource stocks, Chinese stocks and BRIC natural-resource names, calling them “among the most out-of-favor and inexpensive areas of the market.”

While not technically “emerging,” the national markets of Italy, Spain, Greece and Portugal in “peripheral Europe” are so depressed their so-called cyclically adjusted P/E ratios – based on the average earnings of the past 10 years – are below 10. That’s as low as the U.S. 10-year multiple got, very briefly, near the early-2009 bear-market low.

Cheap stocks can get cheaper

Cheap stocks can always get cheaper, of course, and the forces weighing on emerging economies – rising interest rates, stronger dollar, punk commodity prices – don’t appear likely to wane very soon. And a decade’s worth of investment inflows have reversed, potentially with a long way to go before stabilizing.

Yet one argument for U.S.-centric investors to take on more emerging exposure is simply that such a massive spread between domestic indexes and developing markets tends not to be sustainable for long. U.S. stocks now account for nearly half of total world market capitalization, about twice the proportion America’s GDP represents in the global economy.

While the strength of U.S. housing-led, consumer-driven growth stands out against recessionary Europe and hamstrung developed economies, at some point global growth will have to improve for U.S. stocks to maintain their strong trend. If that happens, emerging-market stocks should close some of the gap; if not, the U.S. could give back some of its gains as earnings growth here is jeopardized.

Josh Brown, a financial advisor who blogs at TheReformedBroker, this week, without much hyperbole, called owning emerging-market stocks “the hardest trade on Earth right now.” As he details it, eroding investor faith, nasty volatility and sliding economic fundamentals make EM stocks toxic for professional investors who are judged on short-term performance.

Yet for an investor “with a three- to five-year time horizon, you cannot afford not to” be buying into EM now – “despite whatever pain may come in the near future.”

It’s a cogent point, and gets at the key advantage the little guys hold over the professional money-slinger: An ability to remain patient and arbitrage time horizons by buying more of assets that get cheap and ugly, then waiting for the pendulum to swing in their favor.

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