The coming correction in emerging economies

Investors have enjoyed a great rally in emerging markets, but a real correction could be ahead this year.

By Jim J. Jubak Jan 21, 2011 4:51PM
Jim JubakThursday, I posted that I thought investors were looking at a 5% or so pullback in U.S. stocks -- really nothing more than a necessary decline after a long rally so that stocks can build a new base.

In other words, just one of those dips that you have to live through as an investor. I continue to look for a decent to good 2011.

For U.S. stocks.

Overseas markets are in for rougher going in the first half of 2011. (And yes, I am more pessimistic about overseas markets than I was just a couple of weeks ago.) Many overseas markets are looking at a real correction. 

And remember my Rule of Two? If a correction is a 10% drop in a developed country's market, then in one of the more volatile emerging markets a correction is a drop of 20%. (Remember I’m talking about a 20% decline spread over six months. It’s not going be a crash. You might not even notice. Shanghai is down 13% in the last 12 months. Has it kept you tossing and turning at night?)

I’m going to spell out my opinion for the reasons in detail later, but in a word the problem boils down to inflation. Inflation is out of control, or threatening to run out of control, in many of the world’s emerging economies. Governments there have already started to raise interest rates to slow their economies and to fight inflation. And investors believe that more interest rate increases and measures to tighten the money supply are on the way.
 
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Look at the reaction to China’s announcement of 9.8% economic growth for the fourth quarter of 2010 -- stocks dropped in China (down 2.9% in Shanghai) and in much of Asia because the higher-than-expected growth raised the odds of interest-rate increases that would slow the Chinese economy.

We’re talking slow and not stop. For China, the World Bank is predicting that interest rate increases and other measures to fight inflation will slow the economy to 8.7% in 2011. That would be down from 10.3% in 2010, but we’re not talking recession here.

Great expectations unmet

So why is that drop to 8.7% and its equivalent in other emerging markets so important to emerging market stocks?

Because investors have enjoyed a great rally in these markets off the post-crisis bottom in 2009. Sure, the Shanghai stock market didn’t have a great year in 2010, falling 13%, but it was up 80% in 2009.

And they’ve enjoyed an even better rally in stocks that depend on these emerging economies. For example, copper producer Freeport McMoRan Copper & Gold (FCX) was up 229% in 2009, leaving the Shanghai market’s 80% gain in the dust. And then tacked on another 48% in 2010.

No matter how disciplined an investor you are or how many numbers you crunch, the inevitable tendency after a run like that is to let your expectations creep higher and higher. Demand for copper and copper prices, for example, will go higher in 2011, you come to believe as you justify the price of the stock. Why? Because you’re convinced that demand growth from China will at least keep on at its current torrid rate or better.

In other words, higher and higher expectations get built into the best-performing stocks and stock markets. And when reality turns out to be great but not as great as those expectations, then the markets go through a correction. The greater the degree of over-expectation in those expectations, the greater degree of the correction.

And don’t forget to add in some more points to the downside because of the inevitable overreaction that a 10% drop in what had been market favorites engenders. That last swing to excessive pessimism can turn that 10% drop into 15% or 20%.

Right now, for example, forecasts for growth in copper demand in 2011 are clustering about 6% to 8% growth in 2011. Great, right? Wrong. Last year demand grew by 10% or so, and the price of copper stocks in the market has been increasingly built on the assumption that 2011 would see the same 10% demand growth or better.

And then, of course, there’s the worry that current projections of moderate economic slowdowns in emerging economies -- and China here is the big story -- are going to prove to be optimistic. No one knows how many interest rate increases the People’s Bank of China will order up in 2011. Another percentage point? 1.5? 2? And no one knows whether those increases will do the job.

So we’re getting what I think will turn into a real correction in emerging markets and in what I’d call emerging market-dependent stocks such as copper and fertilizer producers. The odds that this will be a real correction increase because 1) Wall Street strategists are advising U.S. and institutional money to flow to U.S. stocks, and 2) because the fight against inflation in the emerging markets is going to go on for months—long enough to scare and depress investors in these markets and the dependent stocks.

Does that mean you want to abandon these markets and stocks forever? No way. Remember that 80% return from Shanghai and the 229% from Freeport McMoRan. You want to be in these markets and in these sectors for the long run.

Does that mean you should simply take your punishment? No way. Remember that any 20% correction is just a 20% correction on average. Some stocks go down much less and others way more. At a minimum you’d certainly like to minimize your exposure to stocks that belong to the go down more than 20% group.

So what do you do?

At this stage of the correction, while it’s just getting started, you cut your risk. If money is going to get tight and expensive, you don’t want to own companies that are dependent on raising a ton of money in their local markets. I’d think twice about owning shares of companies with really, really ambitious expansion plans unless you’re absolutely convinced that the company can finance those plans with global capital.

At this stage of the correction, while it’s just getting started, you cull those second- and third-choice emerging markets. If you really, really, really liked China, did you find your portfolio adding positions in Vietnam because it was going to be the next China? Or if you liked Brazil, did you drift into Peru? The big emerging markets are risky enough in this kind of environment. If investors decide to cut the risk in their portfolios, they’ll work through the list by selling the riskiest markets, in their minds at least, first.

At this stage of the correction, while it’s just getting started, you cull those second- and third-choice emerging economy-dependent stocks. When a sector is going up, it makes sense to go from owning the leader in the sector to buying a less expensive but less established player. A rising tide does lift all boats. When the tide turns, however, it’s the least established and least familiar names in a sector that get abandoned by investors first.

At this stage of the correction, while it’s just getting started, you focus on valuation. There are still bargains out there in terms of emerging markets—Mexico is a relative bargain I think—and those markets will hold up reasonably well unless the correction turns into something worse. Same with stocks. It’s one thing for a stock trading with a price-to-earnings ratio of 20 to miss earnings by a dime. It’s a disaster if the stock trades at a price-to-earnings ratio of 80.

And last, don’t lose your cynicism. A lot of the money out there will just slosh around at a time like this following the herd and the advice of the moment. Keep on the lookout for stocks that get undeservedly cheap. Stay invested in stocks that don’t have any hot money investors because they’re too homely, too small, and too obscure.

The goal in all of this is to preserve capital now so that you have cash in case stuff that you really want to own becomes cheap in a few months.

I’ll try to illustrate how I think this works in posts on individual stocks over the coming days.

At the time of this writing, Jim Jubak didn't own shares of any companies mentioned in this post in personal portfolios. The mutual fund he manages, Jubak Global Equity Fund (JUBAX), may or may not own positions in any stock mentioned. The fund did not own shares of any stock mentioned in this post as of the end of December. For a full list of the stocks in the fund as of the end of the most recent quarter, see the fund's portfolio here. 

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