January 25, 2010

Emerging Markets vs US Domestic Equities

The markets sold off hard the last two days of last week. Are the moves isolated to US domestic markets, or is something larger at play?

The four weekly percentage change line charts above each plot the iShares MSCI Emerging Markets Index ETF (EEM in red) versus the State Street S&P 500 Index ETF (SPY in black). Red and black vertical dashed lines denote pivot dates of interest; red and black horizontal lines denote swing highs and lows. Red and black circles mark specific points of origin for the percentage change values on each individual chart.

The percentage change calculations originate from different dates on each chart. In the top row, the swing high and low dates in the EEM are used (black). In the bottom row, in black, swing high and low dates for the SPY are used (black). Using the S&P 500 as the basis, the factor of moving in the EEM versus the SPY is stated in red italics. Given these values, we can study the volatility of returns and losses in the emerging markets themselves.

In the top left chart, note the absolute depth of loss in the EEM ETF calculated from its swing high in Nov 07. The loss in EEM (63%) was greater than the loss experienced in the SPY (54%) over the same time period by a factor of 1.1x. Calculated from the same date (Nov 07), the ensuing recovery of Mar 09 - present has also been greater by the same factor (1.1x) with the EEM clawing to near 20% of the Nov 07 high, and the SPY to within 25%. Calculating the percentage change in the lower left chart from the Oct 07 swing high in the SPY ETF produces similar results.

The recovery a calculated from the swing lows, however, tells a different story. We've remarked previously that many global markets did not set new lows as did the US Domestic markets did in Mar 09, bottoming instead in mid to late Fall 08. In the upper right chart, the percentage change values are calculated from the Oct 08 swing low in the EEM ETF. Notice the difference in the factor of recovery since compared to the SPY. The 118% gain in the EEM versus the 32% gain in the SPY from Oct 08 - present was greater by a factor of 3.7x. Calculated from the swing bottom in the S&P 500, the factor is more subdued at 1.6x, but there's no mistaking this rally has largely favored the emerging markets.

Its important to note that deeper loss requires greater gain to generate a new equity high. A 63% loss in the EEM (see bottom red horizontal dashed line, upper left chart) requires a 174% return to recover to break even values seen before the loss ensued (see top red horizontal dashed line, upper right chart). Similarly, a 56% loss in the SPY (see bottom black horizontal dashed line, lower left chart) requires a 127% return to recover those losses (see top black horizontal dashed line, lower right chart).

Though risk would appear on the surface to be greater in emerging markets, the charts above support a bias that the current bullish swing has favored the higher beta trade. Absent leverage, it's unlikely the S&P will see new equity highs anytime soon. Despite a 66% following a 56% loss, the S&P has thus far only come within 27% of its former high. Alternatively, a 118% gain following a 63% loss pulled emerging markets to within 20% of its former high.

Whether the current sell off proves to be a dip or a more serious reversal, technicians need to acknowledge that higher beta plays will be required to recover deep losses. One way to avoid leverage is to follow this reverse beta trade, whereby emerging markets are not seen as the riskier investment, but rather US markets are under performing. It appears the world does not favor US investments over more global plays, and that monies are flowing into international markets. Technicians may also anticipate that should the sell off prove to be a dip, that emerging markets may in fact bottom first - leading to a better trade.

Jeffery E. Lay, CMT
President
Talon Eight, LLC

Disclaimer: This post is intended solely to disseminate information, and is not, and shall not be construed to constitute financial, investment or other similar advice. All posted material should be independently verified for accuracy and current applicability. Readers of this post are referred to the Risk Disclosure for further information.

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