Why Emerging Markets Will Soar in Q4

Emerging Markets have had a lousy 2013.

The threat of tapering by the U.S. Federal Reserve, the biggest emerging-market currency sell-off in five years and improving prospects for the developed markets of the United States and Europe have made emerging markets the red-headed step child among investors.

Emerging-market bond funds have seen 14 straight weeks of outflows, with investors withdrawing $4.56 billion in August alone, according to EPFR Global. Emerging market equity funds have hardly fared better.

But here’s the thing about emerging markets.

Much like other high-risk assets like, say, biotechnology they are driven by “boom” and “bust.”

Back in the late and early 1990s, emerging markets were all the rage and clocked several consecutive 100%+ gains.

Just look at the chart of the pioneering Templeton Emerging Markets Fund, Inc. (EMF) between 1990 and 1993.

And much like biotechnology, emerging markets are overdue for a boom.

That boom may have already started, as the MSCI Emerging Markets Index bottomed on Aug. 27 and has rallied 11.43% since.

And here’s why I think emerging markets will continue to soar in Q4…

1. Because They (Almost) Always Do

As a former emerging markets mutual fund manager, I can reveal that one of the “dirty little secrets” of emerging markets managers is that we expected to make the most money for our clients during Q4.

Sure, there are exceptions, like the period after the collapse of Lehman Brothers in 2008, when investors abandoned all risky assets and everyone headed for the exits at once.

But during normal times — and yes, today counts as normal — the story goes something like this:

Big, institutional money, as opposed to more nimble hedge funds, starts thinking ahead to the next year.

Strategists write reports, committees meet and the powers that be nod their heads in agreement. And institutional managers start implementing their new asset allocation decisions before the start of the year. After all, they want to have them in place by Jan. 1.

That means shifting money out of, say, U.S. markets into emerging markets, or taking money out of India to put it to work in Thailand. This process always tended to move markets in December.

But since they want to get a jump on the competition — after all, why wait to buy at a higher price — they start a bit earlier, say November.

And all of that activity and buying tends to move the prices of markets up.

2. Because You Hate Them

Emerging markets were pegged by most institutional investors as the most popular asset class at the start of 2013. I made the same error.

That positive sentiment stands in stark contrast to a recent survey of 900 Bloomberg subscribers, according to which the formerly high-flying BRICs (Brazil, Russia, India and China) were expected to do the worst among any markets on Earth. India fared the poorest, followed by Brazil, Russia and China. A full 36% of respondents said the BRIC era is over.

Brazil has fallen from its commodities boom-driven perch. Russia has resumed its traditional position as the market that investors love to hate and as the Putin mafia’s playground. India magically transformed from a country that churned out engineers that put the United States to shame into a dysfunctional mess.

The only relatively good news is coming from China. And given that country’s Soviet-like penchant for making up numbers, even that is suspect. Only 14% of survey respondents said China will be one of the two best places to invest in the next year and 23% called it one or two of the worst.

If you are a contrarian investor, there is hardly a better time to buy emerging markets.

3. Because Markets Always Revert To The Mean

The underperformance of emerging markets compared with, say, the United States in 2013 almost has been unprecedented

As of today, the U.S. market has outperformed emerging markets by over 26.7% — just this year. And that’s after the recent double-digit rally in emerging markets.

But as the economist Herb Stein observed, things will keep going the way they do until one day they don’t.

Put another way, emerging markets’ underperformance, compared with the United States, will last — until it inevitably narrows.

And why that gap won’t narrow is because of a collapse in the U.S. stock markets, supported, as it is, by an improving economy.

After all, emerging markets are as cheap as they’ve ever been and are trading at a price-to-earnings (P/E) ratio of roughly 10 versus 15 for the U.S. market.

My prediction?

At some point, emerging markets will have a sustained — and lasting — rally reminiscent of the monster rally in the early 1990s.

That rally may have already started.

Disclosure: I hold the iShares MSCI Emerging Markets (EEM) both personally and on behalf of my clients at my firm Global Guru Capital.

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