Since the August low for global stock markets, one region has enjoyed a very strong rebound rally: emerging markets. That's interesting, because emerging markets, particularly China, were largely responsible for triggering the panic selloff in stocks worldwide.
The MSCI Emerging Market ETF (EEM) has gained 18.5% since late August, which is far better than the bounce in SPDR S&P 500 ETF (SPY), which is up just 11.5% over the same period.
But the question for investors: Is this performance sustainable? The answer depends on which emerging market you focus on.
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Next, the global economy began slowing at the same time the U.S. dollar strengthened. This triple threat was too much for most emerging economies where growth has slowed considerably.
For example, China, the largest emerging market, reported gross domestic product growth of just 6.9% this week. That's the slowest expansion since the Great Recession ended in 2009, and below Beijing's official growth target of 7%.
But it's not just China. The International Monetary Fund has been steadily cutting GDP growth estimates across the board for emerging markets. According to IMF data, 2015 will be the fifth-straight year of slowing emerging-market growth, with two of the four BRIC emerging-market giants — Brazil and Russia — already in recession.
|Investors have been running for cover, selling emerging market investments in droves.|
As a result, investors have been running for cover, selling emerging-market investments in droves. In fact, capital flowing out of emerging markets will exceed inflows this year for the first time in more than 25 years. According to data from the Institute of International Finance, investors will yank $540 billion out of emerging markets in 2015 with nearly half that amount, or $260 billion worth of selling, in the third quarter alone!
So with so much selling, how are emerging markets able to outperform over the past two months? It's a two-part answer:
#1: Emerging markets are dirt cheap today, offering compelling valuation after underperforming the U.S. and other developed stock markets in recent years, and ...
#2: Investor sentiment may be shifting in favor of cheaper emerging markets as a result.
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First, the MSCI Emerging Market Index is trading at just over 12 times earnings today. That's an absolute bargain compared with global stocks as a whole, which are priced at nearly 17 times profits, and the S&P 500 Price-Earnings ratio of over 18!
Second, the recent positive performance from emerging markets looks like more than just a dead-cat bounce. That's because the price gains are backed up by big money inflows turning positive.
In just the past week alone, $700 million flowed into emerging-market stocks, the first capital inflows in 14 weeks, according to data from Merrill Lynch. Plus, another $400 million flowed into emerging market bonds, the largest inflow in five months!
This may be only the start of a massive reversal of fortune for emerging markets. That's because global fund managers are massively underweight emerging market stocks right now, if not outright short these markets.
As you can see in the graph above, recent inflows to emerging-market stocks led to a slight rebound in the asset allocation to emerging stocks among global fund managers, but they are still 28% underweight the asset class, up from an all-time record low of 34% underweight just last month.
This tells me we could be at or near a key turning point for investor sentiment toward emerging markets, and if the pendulum keeps swinging back toward positive territory, it has a very long way to go.
If capital inflows to emerging markets continue, or even accelerate from here, then some of the biggest beneficiaries are likely to be Asian markets were earnings growth is faster and valuations cheaper than any other region of the world.
As I pointed out earlier, emerging-market valuations are among the cheapest worldwide at just 12 times trailing earnings. But if you look at forward earnings estimates, the story gets even better. Emerging markets have a P/E of just 10.8 times forward earnings.
And in terms of potential profit growth, emerging markets really stand out with earnings expected to grow 10.4% next year, and 11.6% over the next two years. Meanwhile, the S&P 500 Index has a rich forward P/E of 16.1 times earnings and profits are expected to grow just 9.8% next year.
That's why the recent outperformance in emerging-market stocks may only be the start of a much bigger move to the upside. Keep a watchful eye on the trend in capital flows into emerging markets to confirm this.
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The investment strategy and opinions expressed in this article are those of the author's and do not necessarily reflect those of any other editor at Weiss Research or the company as a whole.