Getting frothy in the EM world?

Many of you know I am a principal author in the Worldview series on Emerging Markets (EM) and have studied, lived, worked in, and commented on many emerging market issues - economic, political, financial - for the better part of two decades. I have been an advocate of incorporating EM into one’s investing vision for some time now.

I often find my best blog pieces are actually developed in response to other people’s questions, and so this one is related to a discussion I had with some young CFA candidates today. The question was:

“[Is] anyone else tilting their personal portfolios heavier towards the emerging markets sector for the next 12-36 months?”

The answers to questions are sometimes much more involved than one initially expects. This was mine (slightly edited to remove colloquialisms).

I think EM should definitely be in a portfolio with a long time horizon, but I think EM may be getting a bit overvalued and frothy in the short term. I need to go run the numbers to be absolutely sure, but this is my impression from the news feeds, talk, and data that I see. Not that the newsfeeds, and data, and talk are actually saying that themselves, but put together, that's my conclusion.

My main concern is that if you see strong growth in the US economy, or even higher real yields on long-term Treasurys, there's a lot of capital that will come rushing back to the US. If, in addition, Europe gets its act together in 2011 (less likely), then it will really surge back to developed markets. If you look at the market capitalization of stock and fixed income (and real estate) markets in the developed world, you'll realize that it actually only takes a small improvement in either of these very large portions of the world economy to cause a large (as a proportion) exit of capital from EM.

Medium term, there is a tendency for people living in EMs to get overconfident and start allocating capital inefficiently when it comes to easily (such as foreign pension funds throwing money at any public EM company, because it feels like part of the EM story). Now, part of the EM story is that EMs have become a bit more professional about applying investment money, but even professionalism has its limits. Even here in the supposedly we-know-better developed world, easy money led to really stupid investments, like mortgages for people who clearly are lying on their applications. It can happen there too.

Remember also that people who "play" the stock market in places like China and India don't have generations of experience with these kinds of instruments, and therefore the ordinary Chinese, Indian, Brazilian, and so forth may have very unrealistic ideas like "stocks always go up." Even in developed markets, we’ve had this problem with the tech bubble and also the housing bubble. I don't necessarily see this as an EM problem for 2011, but it is definitely a medium term problem, and I fully expect a bubble and meltdown in at least one major EM stock market in the next 5 years, and very likely in half that time. One has to ask oneself... is the economy and stock market in many EMs more like the US the 1920s or the 1950s? Is the US and Europe’s economy and market more like the 1930s, or the 1970s? While we’re thinking about that, we might as well ask if Japan is like anything we’ve ever seen at all?

My general thinking is to have EM in your portfolio, but underweight it in 2011 in preparation for “capital reflux.”

But now, that actually begs the question of what it means to be underweight EM. If you just used historical MVP optimization (or one of its robust variants) and a CAPM type pricing model, the historical series should have its expected returns and allocations biased downwards because the lower historical EM returns don't match expected returns in the future environment. So you would still want to have overweights in EM based on MVP and historical averages.

If your model corrects expected returns for an increase in long-term expected growth rates, but does not consider valuation, then you will get allocations that are higher than what you would get by using the simple historical average. My sense is that this is what people are doing and talking about when they are allocating into EM, to the extent that they are not simply chasing performance. These allocations are probably higher than optimal for 2011 because people are ignoring the effects of sentiment and the potential return of capital to developed markets in a post-crisis world.

If you include valuation into your asset pricing model, then you may get sensible allocations, but part of the challenge is that figuring out what are appropriate valuations is made more tricky by differences in accounting standards and levels of market risk in different markets.


The last thing I'd add (and which admittedly runs counter to most of what I said above), is that large institutions may actually take quite a while to update their allocations and approach to emerging markets. If you are a large fund, like CalPERS or something, it's harder to say, "Let's massively increase our EM exposure,” than if you are an individual investor. Yes, large institutions can do this, but it takes committee meetings, and consultants to come in and talk and a lot of haggling over who is going to be blamed if anything goes wrong. So that means that large institutions may be upping their allocations slowly and steadily over time, and so valuations could go higher not because growth prospects have increased in EM markets, but simply because large investors have finally gotten around to getting in in scale. They are so large, that their mere presence inflates valuations.

Institutional money mangers also get paid highly to "not screw up," which means that the incentives for intelligent risk taking are not as strong as one might hope, and the result is that it’s often safer just to hug benchmarks while taking just enough risk to justify being paid more than an index fund manager. When they do take risks, often times they are performance chasers. Or they do things where they can use the excuse, "but who could have known it would end like this? MBSs have been delivering excellent returns for several years in a row; we would have been irresponsible if we hadn't done it too." And institutions can be so large themselves that they will move the markets as they invest, seemingly confirming their own brilliance as they enter the market (but then get slammed because of liqudity problems when things go badly). That’s a serious problem for institutional investors, and one of the reasons that it may take them quite a bit of time to get to the levels of allocation that many macro strategists find sensible.

As a smaller investor, one could potentially ride that valuation wave, provided the risk allocation and time horizons are suitable for wade out the inevitable bumps along the way. An emerging risk over the long term will be “institutional panic,” which could resemble the Asian crisis of 1997. When this happens, it will surprise because it could be a very minor stumble in EM markets that provokes a panic, and the reaction will be seemingly incommensurable with the economic conditions on the ground. The true risk in the institutional panic scenario is not economic conditions in the emerging market, but behavioral aspects (panic and and “butt covering”) of institutional investors who may form a large portion of total investment in any one EM market.