Emerging-market equities have underperformed mature-market equities since the start of the year, with the MSCI Emerging Market Index down 1.4% while the MSCI World Index is up 2.04% and the S&P 500 4.6%. This raises the question of whether investors have lost faith in emerging-market equities.
Let us first look at the issue of valuation. In order to compare emerging-market equities and the S&P 500, I used two exchange-traded funds (ETFs), namely iShares MSCI Emerging Markets Index Fund (EEM) and iShares S&P 500 Index Fund (IVV). I calculated the annual trailing dividend yields on both since 2004 on a daily basis and compared them in the graph below. Please note that the prices I used were in fact the net asset values of the funds.
But why the dividend yield and not the price-to-earnings ratio, you may ask? Apart from a lack of information regarding the price-to-earnings ratio, I believe dividend yield is a better indication for investors in the ETFs as it is part of their actual returns. Furthermore, dividends are unaffected by accounting policy changes and adjustments that frequently occur and distort the earnings base of companies and indices.
Sources: iShares; Plexus Asset Management.
It is evident that the EEM has generally traded at a premium to the IVV since the EEM was launched, with the dividend yield significantly lower than that of the IVV. The major exception was from the third quarter of 2008 to mid-2009 during the global liquidity crisis sparked by the Lehman saga where the EEM actually traded at a discount to the IVV.
Why should the EEM trade at a premium to the IVV? The age-old investment adage of “relative earnings drive relative price”, and in this case “relative dividends drive relative price”, applies. The compounded growth in dividends of the EEM since 2004 has been 11.6% per annum while that of the IVV has been 1.5% per annum.
Sources: iShares; Plexus Asset Management.
The reason why the EEM moved from a premium rating to a discount to the IVV is evident in the graph below. The market expected dividends for the EEM in 2009 to be sliced significantly more than those of the IVV on the back of 2008/2009’s liquidity crisis.
As the liquidity crisis eased because global trade normalised, the price of EEM relative to IVV reverted to the relative dividend index and thereby moved to trade at a premium rating to the IVV. Since the fourth quarter of last year the gap between the relative dividend and price indices has opened as more and more black swans entered the global pool. The gap surged at the end of the second quarter, though, after both the EEM and IVV went ex dividend in June.
Sources: iShares; Plexus Asset Management.
This resulted in the EEM trading on a par with IVV on a dividend yield basis.
Sources: iShares; Plexus Asset Management.
What this is telling me is that the EEM is currently priced in a similar way as in June 2008 just before the 2008/2009 liquidity crisis started in earnest.
Sources: iShares; Plexus Asset Management.
My reading is therefore that the EEM is priced for an imminent global financial disaster.
Sources: iShares; Plexus Asset Management.
I do not know whether such a disaster is indeed imminent, but I can play around with various scenarios, such as the Eurozone crumbling, the debt situation of local authorities in China catching up with them, another earthquake disaster in Japan, etc. But no one can tell.
My research also revealed an interesting feature about the EEM. Its rating relative to the IVV has been steadily falling over the years with the relative dividend gradually trending upwards. The dividend yield of the EEM relative to that of the IVV is currently approaching the upward channel of the trendline (which is the trendline plus 15 basis points).
The last time, barring the 2008/2009 crisis period, the relative rating of the EEM found itself at the upper end was in December 2006 through February 2007, after which the EEM outperformed the IVV by a significant margin.
Sources: iShares; Plexus Asset Management.
If I assume that the historical dividend growth rates of EEM and IVV remain unchanged at 11.6% and 1.5% respectively, it means that to receive $1 dividend in 5 years’ time I am paying USD 32.09 now for the EEM compared to $51.57 for the IVV – a 37.8% discount!
Yes, despite the risks, I can live with that. Put another way, given the respective dividend growth rates for the EEM and, IVV it will mean that the relative dividend yield of EEM to IVV will swell to 1.61. Allowing for a further derating from the current dividend yield ratio of 1 to 1.1, it means a relative price outperformance of 46%.
But what really caused the recent slump in the MSCI Emerging Markets Index? To eliminate the distortions caused by currencies, I decided to convert the MSCI Emerging Markets Index from US dollar to Swiss franc.
Are you prepared for this? The MSCI Emerging Market Index in Swiss franc has an extremely good correlation with China’s CFLP manufacturing PMI. This demonstrates the importance of China’s economy, and especially the manufacturing sector, for emerging-market equities.
Sources: CFLP; Li & Fung; I-Net Bridge; Plexus Asset Management.
It is no coincidence, though. Look at how the monthly high/low of the Shanghai Composite Index corresponds with the CFLP manufacturing PMI.
Sources: CFLP; Li & Fung; I-Net Bridge; Plexus Asset Management.
It is evident that the Shanghai Composite Index is currently anticipating a jump in July’s CFLP manufacturing PMI. But will it happen? The impact of my calculated seasonality of the PMI on the Shanghai Composite Index is clearly evident in the graph below. It also indicates that the players in China’s equity market as reflected by the Shanghai Composite Index may be a bit optimistic.
Sources: CFLP; Li & Fung; I-Net Bridge; Plexus Asset Management.
What stands out, though, is that the manufacturing sector in China is on the verge of a period of seasonal strength. that will last through end September.
Sources: CFLP; Li & Fung; I-Net Bridge; Plexus Asset Management.
On the other hand, the MSCI Emerging Markets Index in terms of Swiss franc is solidly anticipating the seasonally weak PMI. I think there is a more than even chance that the MSCI Emerging Markets Index in terms of Swiss franc will continue to follow the seasonal pattern in China’s CFLP manufacturing PMI in coming months. I am thus inclined to believe that July will also mark a seasonal low for emerging-market equities in general.
Need I say more?
No comments:
Post a Comment