Emerging Markets

Does a High Dollar Lead to Poor Emerging Markets Returns?

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Quiz!

What does a dollar far above average do to future emerging markets returns?

  1. It hurts emerging markets returns.
  2. It helps emerging markets returns.
  3. There is no correlation between a very high dollar and future emerging markets returns.

Does a High Dollar Lead to Poor Emerging Markets Returns?

I’ve seen articles explain how a high dollar hurts emerging market (EM) economies. With the dollar recently reaching the highest level since late 2002, some articles gave concerning messages related to emerging markets investments.

Historical evidence for the opposite: The history of EM investments shows opposite results. When the dollar reaches high levels, future returns of EM tend to be stronger than when the dollar is low. For example, the recent time we had such a high dollar (2002) was around the beginning of phenomenal 5 years for diversified EM stocks.

Explanations: Once the dollar is at unusually high levels, the negative effect of the dollar is priced into EM stocks, with lowered valuations (price/book and price/earnings). Given that the dollar is cyclical, at some point we got a reversal, with a declining dollar. Some of the logic of the articles can be used to explain the benefits of the declining dollar, helping EM stocks.

Caveats: This quick read shows counter evidence + logic to many articles you may read in some prominent sources. There are still big unknowns. The dollar may have just peaked, or it may go up further. The goal of this article isn’t finding the exact peak, but looking at odds for further increases vs. decreases. When a cyclical measure is above average, you would expect higher odds for the measure to go lower than higher.

Quiz Answer:

What does a dollar far above average do to future emerging markets returns?

  1. It hurts emerging markets returns.
  2. It helps emerging markets returns. [The Correct Answer, but read explanation]
  3. There is no correlation between a very high dollar and future emerging markets returns.

Explanation: A rising dollar lowers the value of emerging markets (EM) returns as measured in dollars. So, the past EM returns leading to the dollar highs are hurt. Future emerging markets returns depend on the future movement of the dollar. From a level above average, the dollar is more likely to decline in the future. That would lead to above average returns. A caveat is that this simply reflects odds, not guarantees or specific timing.

Disclosures Including Backtested Performance Data

Can You Make Money Buying Stocks that Declined?

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Quiz!

Can You Make Money Buying Stocks that Declined?

  1. No
  2. Yes, with a combination of a diversified stock portfolio along with very low valuations.
  3. Yes, after a careful analysis of buying near the bottom.
  4. Yes, with diversified stock investments.

Can You Make Money Buying Stocks that Declined?

When you see your stock portfolio decline, is your instinct to double down and invest more, or sell and wait on the sidelines until the sky clears? Knowing whether a recovery at a reasonable timeframe is likely depends on multiple factors. Here are cases that could lead to disappointment:

  1. If your portfolio includes only one or a few stocks, it may never recover. Many companies go bankrupt every year.
  2. If your portfolio reached extremely high valuations, as measured by price relative to book value (or liquidation value), you could make money by holding on until past the recovery, but the recovery could be many years away.

If your portfolio is diversified and has very low valuations, you may enjoy seeing a recovery within a reasonable timeframe, making you money. This is far from guaranteed. Here are steps to increase your chances:

  1. You need a robust risk plan, that accounts for a significant amount of additional declines, with a prolonged timeframe to recovery.
  2. With the right risk plan in place, you need to be 100% committed to your plan. When additional declines occur, you are not likely to see headlines saying “don’t worry, everything will be fine, this is a temporary dip”. The headlines are likely to be between negative and terrifying. Sticking with the plan requires putting all emotions aside, focusing on your risk plan, and following it mechanically – not for the faint of heart!
  3. Buying after declines requires a great deal of humility. You may have strong gut feelings on the “obvious” next move for stocks. Avoid setting any short-term expectations – the next move is mostly influenced by information that is not available at the moment.
  4. Start by having your normal allocation. Then, given the uncertainty, it helps to have a multi-step plan, with incremental small investing with every material additional decline. Allow for more declines than you can imagine. This can empower you knowing that you are proactive with additional declines.
  5. An incremental investing plan is smart in theory, but can be tough to execute. On the way down, you are likely to feel increasingly wrong. Remember that your goal is not to call the bottom – a very tough thing to do, but to emphasize extra investing when the odds are stacked more strongly in your favor, and the risks are lower.
  6. If you don’t have long-term valuation data for your investment, one alternative is comparing the 10-year performance relative to the long run. 10-year outperformance relative to the long run could mean high valuations and high risk.
    1. For example, the S&P 500 had far above average returns in the past 10 years, leading it to reach near record valuations. Buying on the dip beyond your normal allocation in such cases can be very risky.
    2. On the other hand, Emerging Markets Value investments had unusually low returns in the past 10-years, leading to below average valuations. Buying on the dip beyond your normal allocation in such cases may be profitable, subject to all the precautions described above.

Quiz Answer:

Can You Make Money Buying Stocks that Declined?

  1. No
  2. Yes, with a combination of a diversified stock portfolio along with very low valuations. [Correct Answer]
  3. Yes, after a careful analysis of buying near the bottom.
  4. Yes, with diversified stock investments.

Explanations:

  1. While there are no guarantees, with the right plan, you can make money buying stocks that declined – read on.
  2. Diversified stock investments tend to recover after declines. As long as you hold onto the investments until they hit a bottom, fully recovered and reached new peaks, you can make money. The low valuations help avoid some of the longest declines of stocks.
  3. A careful analysis may or may not be successful at identifying the bottom. In addition, a concentrated portfolio of one stock may never recover.
  4. While diversified stock investments tend to recover after declines, if the valuations are extremely high, it may take many years to enjoy a gain.
Disclosures Including Backtested Performance Data

Testing Emerging Markets Value Investments in a Simple Graph

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Quiz!

Which of the following are good ways to judge the future of portfolios of value stocks?

  1. Look at their 1 year performance. Strong performance is good news.
  2. Look at their 1 year performance. Strong performance is bad news.
  3. Look at their 10 year performance from all historic cases with valuations similar to today. Strong performance is good news.
  4. Look at their 10 year performance from all historic cases with valuations similar to today. Strong performance is bad news.
  5. Look at their 10 year performance. Strong performance is good news.
  6. Look at their 10 year performance. Strong performance is bad news.

Testing Emerging Markets Value Investments in a Simple Graph

Value stocks are priced low relative to their intrinsic value (low Price/Book, or P/B). Value investing makes logical sense: when buying cheap stocks, you can expect to enjoy higher returns. It is not only logical, but also supported by nearly 100 years of evidence. This is all nice, until you look at the past 10 years and see that value underperformed growth (high Price/Book) for the whole period. This raises the suspicion of a new normal. Maybe the entire group of companies with low prices has something wrong with them, and their value will go down over time, to justify the low price?

There is an easy test to differentiate between bad companies and cheap investments:

  1. Bad companies: The underperformance is explained by underperformance of their book values relative to the rest of the market. This is why Warren Buffett tracks the book values of his companies more than prices.
  2. Cheap investment: A lot of the underperformance of value stocks is explained by a change in their valuations (P/B) relative to the rest of the market.

As an example, here is a comparison of DFA funds, one representing overall Emerging Markets (EM), and the other representing EM Value. The graph divides the valuations (P/B) of EM by EM Value. A high value represents an increase in the price paid for all of EM relative to the price paid for EM Value stocks.

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For the year (2020), EM Value underperformed EM by about 11%, while the valuations difference increased by 15%. This means that the value companies, as measured by their book value, did 4% better than the overall market. This supports the thesis that these investments are simply cheaper, and you may reap the benefit as the valuations continue their cycle.

Quiz Answer:

Which of the following are good ways to judge the future of portfolios of value stocks?

  1. Look at their 1 year performance. Strong performance is good news.
  2. Look at their 1 year performance. Strong performance is bad news.
  3. Look at their 10 year performance from all historic cases with valuations similar to today. Strong performance is good news. [Correct Answer]
  4. Look at their 10 year performance from all historic cases with valuations similar to today. Strong performance is bad news.
  5. Look at their 10 year performance. Strong performance is good news.
  6. Look at their 10 year performance. Strong performance is bad news.

Explanations:

  1. You cannot conclude anything positive or negative from a 1 year period.
  2. See #1 above.
  3. The combination of averaging many 10-year stretches with a focus on pricing (valuations) similar to today, gives useful information.
  4. See #3 above.
  5. After a decade of unusually good returns, the risk of a weaker decade goes up, so it is not necessarily a good sign.
  6. After a decade of unusually good returns, the risk of a weaker decade goes up, but it is also not a guarantee for a bad next decade.
Disclosures Including Backtested Performance Data

Do Rising U.S. Interest Rates Hurt Emerging Markets?

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Quiz!

Would you expect emerging markets investments to go up or down when interest rates go up in the US?

  1. Up.
  2. Down.

Do Rising U.S. Interest Rates Hurt Emerging Markets?

There is a widely held belief that when the US Fed (Federal Reserve) raises interest rates, emerging markets investments should decline.

Why do people expect emerging markets to get hurt when US rates go up?

  1. Stronger dollar: When US rates go up relative to rates in other countries, people can earn a higher rate on savings in the US. This would lead to money flowing from other countries to the US, which would strengthen the dollar.
  2. Higher borrowing costs for emerging markets: Many emerging markets companies borrow in dollars. If a Chinese company earns money in yuans and borrows in dollars, a stronger dollar would make the loan more expensive in yuans, hurting the company.

Reality is the opposite!

While the logic seems sound, reality in the past 20 years has been the opposite. The table below tracks the returns of ET (Extended-Term Component), a portfolio focused on emerging markets, in periods of rising and declining rates in the US:

Period Start

Period End

Change in US rates

ET Returns

12/31/1998

5/16/2000

+1.75%

+58%

5/16/2000

6/25/2003

-5.50%

-11%

6/25/2003

6/29/2006

+4.25%

+169%

6/29/2006

12/15/2015

-5.25%

+20%

12/15/2015

9/28/2018

+2.00%

+50%

Observations & notes:

  1. In all rising-rate periods, ET gained substantially.
  2. In declining-rate periods, ET had much worse results, with negative to low-positive returns.
  3. Market tops and bottoms didn’t coincide perfectly with the borders between the periods. Measured from the turning points in the portfolio, the results are substantially stronger.

Why do emerging markets go up when US interest rates go up, and vice versa?

The Fed reacts to the world economies when setting the interest rates. It focuses on the US, but considers the rest of the world as well. Specifically:

  1. When the economy shows signs of weakness after a period of expansion, the Fed lowers rates, to support the economy.
  2. When the economy turns around after a period of contraction, the Fed raises rates to moderate the expansion.

While I wouldn’t count on emerging markets to go up perfectly whenever US rates go up, the data is useful in avoiding expecting the opposite.

Quiz Answer:

Would you expect emerging markets investments to go up or down when interest rates go up in the US?

  1. Up. [The Correct Answer]
  2. Down.

Explanations: Read this month’s article for an explanation.

Disclosures Including Backtested Performance Data

2 Hidden Benefits of Emerging Markets

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International markets offer a tradeoff of higher potential returns at the price of higher volatility, when compared to the U.S.

Emerging markets offer even higher potential returns, at the price of even higher volatility, when compared to both the U.S. and international markets.

While these characteristics are well publicized, emerging markets investments hold two additional benefits that are typically not discussed:

  1. Technology Leaps: The technologies developed in the U.S. and other developed countries are readily available to emerging markets, allowing for leaps to the newest technologies.
  2. Rotating Countries: The most advanced countries keep being replaced by less advanced countries in emerging markets funds. As long as there are countries that are not advanced enough to be part of emerging markets funds, we get a fresh supply of countries that can leap forward.

These benefits are the key for emerging markets investments sustaining a very high growth rate.

Disclosures Including Backtested Performance Data