A Bold Call on a Short-Term Bottom in Emerging Markets

Japan’s Nikkei 225 index slumped 24% last month, the worst performance in its 58-year history. The S&P 500 closed down 16.9%, its worst run since a 21.8% fall in October 1987. In Europe, the FTSE Eurofirst 300 slid 13.1%, the most since September 2002. In London, the FTSE 100 lost 10.7% last month — actually improving on September’s loss of 13%.

Yet the market rally last week showed that some degree of stability may be returning to global markets. Here’s why this week’s Global Bull Market Alert pick, the iShares MSCI Emerging Markets Index (EEM), is a bet that the initiatives of policy makers across the globe will be sufficient to trigger a sustained, short-term bounce in emerging markets stocks between now and the end of the year.

First, the policy responses to the global economic crisis have been both massive and coordinated. The European Central Bank has entered into foreign currency swaps with Iceland and Switzerland, even though they are outside the eurozone. The European Union joined forces with the IMF and the World Bank to provide loan facilities totalling $25 billion to Hungary. Last week, the U.S. Federal Reserve opened swap lines of $30 billion each to Brazil, Mexico, South Korea and Singapore. All of these efforts combined will ease the shortage of dollars that has ravaged emerging markets. As one analyst put it: "This is the turning point, not just for emerging markets, but for the whole of the credit crisis." Added another: "The world is finally starting to sort itself out. It is difficult to correct the imbalances in the markets from one day to the next, but this does look like it establishes a floor."

Second, emerging market equities are as cheap as they have ever been. Last week’s rally notwithstanding, the benchmark MSCI Emerging Markets index is trading at a P/E in the single digits, down from 18.5 a year ago. Markets such as Turkey and Russia are trading at a P/E below 5. And while global growth has slowed, emerging markets are still expected to grow at an average of 5% in 2009, compared with 1% expected in developed markets. This adds up to considerable upside in global markets.

Finally, as last week’s sharp rally in global markets suggests, emerging markets can turn on a dime. Since hitting a four-year low on Tuesday, the benchmark MSCI emerging equities index rocketed more than 24%. Fear can rapidly turn into greed. However, it’s not only the timing but also the sustainability of these jumps that is tough to judge. This week’s recommendation is all about a “relief rally” to lock in relatively short-term gains between now and the end of the year — traditionally the strongest time of the year for emerging markets.

So buy the iShares MSCI Emerging Markets Index (EEM) at market today, and place your stop at $18.50. This pick is going to be extremely volatile. So you may want to take half of your normal position size here, and add to it as the trend becomes more established.

Portfolio Update

It’s worth summarizing our basic Global Bull Market Alert strategy. Maintain your “core” defensive posture by keeping most of your capital in your currency bets, which still have plenty of (relatively steady) legs left. At the same time, be prepared to gradually increase your position in the markets — as we have done with the ProFunds Ultra S&P 500 ETF (SSO) two weeks ago and the iShares MSCI Emerging Markets Index (EEM). Because both of these positions are extremely volatile, you may want to limit your position size in each.

The ProFunds Ultra S&P 500 ETF (SSO) was the big performer of the week, soaring 20.9%. Expect this position to move in line with this week’s bet on EEM.
established.

The Market Vectors Double Short Euro ETN (DRR) rose to a peak of $62.00 last Monday, before correcting and ending the week slightly down. Nevertheless, the short position in the euro has been the place to be. The euro’s performance in October against both the dollar and the yen was the weakest since the currency was created in 1999. Further rate cuts this week by the European Central Bank will ensure that the euro continues its downward trend.

Direxion Funds Dollar Bull 2.5x Fund (DXDBX) corrected slightly this past week, even as the the long-term upward trend remains firmly intact. Expect this position to strengthen as deleverging gains pace and U.S. investors repatriate their cash into the Treasury market.

Your short position in the CurrencyShares British Pound Sterling Trust (FXB) suffered slightly as the GBP rallied. With the British economy heading into recession, and sterling in a freefall, I expect the British currency to breach its lows of two weeks ago relatively soon. Consensus on sterling’s level have now dropped to $1.40 to the pound. That’s about 12% below the current level of $1.60, and a third below sterling’s peak of $2.10 back in November of last year.

Your position in the CurrencyShares Japanese Yen Trust (FXY) fell back slightly last week as investor risk appetite returned and the yen came off its 13-year highs against the dollar. The yen will resume its upward trend as the carry trend continues to unwind.

P.S. Surging oil and food prices, as well as deteriorating economic confidence, have stoked inflation fears around the world in recent months, leaving volatile markets and jittery private investors in their wake. In times such as these, it’s good to have this forum to discuss key developments and to hear from the best financial minds in the world. I invite you to join me at the 4th Annual World Money Show London, 14-15 November, at the Queen Elizabeth II Conference Centre. Call 800.970.4355 and mention priority code 009613 or visit The World Money Show London to register FREE today!