Markets shift back to risk off
What to sell and buy (eventually) in emerging markets
The global markets have swung to their risk off posture.
The drivers are, as usual, global central banks. Specifically, traders fear that the Federal Reserve will begin tapering off its $85 billion a month in purchases of Treasuries and mortgage backed securities "soon." (More later on what the market action suggests that traders think "soon" might be.) And that the lack of more stimulus from the Bank of Japan at its meeting Tuesday means that the bank might be backing away from its efforts to weaken the yen and bolster Japanese exporters.
As usual in the current central-bank driven market, while the fear driving traders to flee risk and pile into safe havens starts with central banks in the developed economies, the biggest damage is in emerging markets.
So on Tuesday Thailand’s stock market fell 5%, Philippine equities dropped 4.6% and Indonesian stocks declined 3.5%. On Wednesday Thailand was down another 1.32%, the Philippines was 4.64% lower and Shanghai had dropped 1.33%. Before the drops the Philippine stock market had traded at 20 times projected 2013 earning and Thai shares sold for 2.5 times book value. By both of these measures these stocks were more expensive than U.S. equities. The Thai baht, the Philippine peso and the Indonesian rupiah had all climbed this year to a level close to their 1996, pre-Asian currency crisis highs.
I think we’re seeing a lot of trading positions unwound. In the U.S. we’re seeing a sell-off in inflation-protected TIPS. The search for inflation protection had driven real yields on TIPS negative. Now money seems to be moving out of TIPS into things such as Treasuries that, suddenly, pay a real yield again. In Japan we’re seeing traders unwind at least some of their weak yen/stronger Japanese stocks trade. That unwinding has driven the yen from a low of 103 to the dollar to a high of 95 to the dollar. On Wednesday the yen was trading at 95.86 to the dollar at 1:50 p.m. New York time.
The problem is that, when trades start to unwind, traders looking for an exit can find the only available exit price lower than they hoped. They are then left with the option of holding on, in hopes of a better exit or taking what they can get today. When everybody is selling, taking what you can get today seems a good option -- especially when you can’t put your finger on a catalyst that might create a market bounce. The Federal Reserve does meet on Tuesday and Wednesday of next week -- but it’s unlikely the announcement and press conference on Wednesday, June 19, will offer enough to end the market’s fear of a sooner rather than later tapering off Fed purchases.
Moves on fear like the current one always run to excess. I think you can make a case that the market is already at excess -- "soon" for the Fed’s tapering off of purchases is feared to be July, and the market seems to be pricing in an end to the entire purchasing program and actual interest rate increases in early 2014. That seems really unlikely. The Fed has repeatedly said it will look for data indicating the U.S. economy is generating enough jobs to cut unemployment to 6.5% or so. That kind of strength just isn’t present in the current data. However, I don’t think we’ve run all the way to excess, even in developed markets.
It’s important to remember that moves to excess in emerging markets are more excessive than in developed markets. Brazil, for example, has moved close to what would be bear market territory -- a drop of 20% or more -- for a developed market, but in an emerging market I don’t think that marks a bottom. (The iShares MSCI Brazil ETF (EWZ) is down 17.5% from its March 8 peak.) Emerging markets have a history of moves that are twice as violent (my rough rule of thumb) as in developed markets. For example, the Brazilian market fell 30.3% from March 1, 2012 to June 28, 2012 before bouncing 15.1% by September 13.
That’s unfortunately all too typical of volatility in emerging markets.
So, what do you do?
At this point, I think we’re looking at further drops in the most exposed/over-valued emerging markets. I’d put Brazil in that group, because the economy has deteriorated so markedly in the last six months. I’d put Indonesia, Thailand, Turkey and the Philippines in that group on valuation -- and because these markets are historically dependent on cash flows from overseas investors. (Mexico is over-valued, but its economy is so closely linked to the relatively strong growth story in the United States that I think it will escape the worst of the damage to emerging markets.)
Within those markets I’d look for the biggest damage to take place in the big cap, high profile stocks that make up a huge share of the ETF portfolios for these countries. The downside of ETFs is that, because they make moving money in and out so easy and because the indexes that ETFs are built on are, by and large, weighted by market cap, selling by overseas investors hits stocks such as Brazil’s Vale (VALE) hard. Vale represents 8.5% of the iShares MSCI Brazil ETF. Shares of Vale are down 21.7% from May 8 through Wednesday. In the Philippines the ADRs of Philippine Long Distance Telephone (PHI) are down 13.7% from May 15 to $67.35 Wednesday in New York trading. That’s a significant drop for a stock with a 4.3% dividend yield.
In contrast a Brazilian consumer stock such as Natura Cosmeticos (NUACF) that isn’t one of the top 25 holdings of the iShares MSCI Brazil ETF and that trades in Sao Paulo instead of New York is down only 6.4% from its May 27 high to Wednesday's trading in Sao Paulo.
So again, what do you do?
I think cutting positions in emerging markets -- especially the most overvalued and weakest on economic fundamentals -- is still advisable. I don’t think the risk off trade is done. In individual stock holdings in these markets I’d look to cut positions in stocks with the biggest exposure to the global economy—especially global commodities—and that have the biggest representation in single-country ETFs.
I’d look to create a significant cash cushion so that I can buy into emerging markets when this sell off has sold off further. If cutting positions in the emerging market stocks that I’ve targeted above won’t give you enough cash, I’d look to sell a few developed market stocks that have their own exposure to global export markets. (I’ll suggest the kind of developed market stocks that you might think of selling to raise cash in a post on Thursday, using the positions in my Jubak’s Picks portfolio as an example.)
Doing this selling will give you some protection from a further sell off -- but the major goal here is to enable you to buy into emerging markets when the drop is over. I’m especially interested in adding Indonesian and Thai food stocks on this drop, since I like everything about their stories except their current prices. (I’ll give you some names Thursday.)
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. The fund may or may not now own positions in any stock mentioned in this post. The fund did own shares of Natura Cosmeticos as of the end of March. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio.
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" I think you can make a case that the market is already at excess -- "soon" for the Fed’s tapering off of purchases is feared to be July."
Well, Jim how's that going to happen if Uncle Ben wants to see 4 months of 200K jobs growth and an unemployment rate under 7%? Let's see - July, Aug, Sept, Oct for jobs would mean the earliest we could see an easing in purchases would be Dec. 17-18, 2013. But don't hold your breath on July's job creation being greater than 200k. The markets are a year early in all this fuss because that's what makes the VIX go up and traders happy. How much you want to bet rates are back down by Sept?
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