It’s early. The results are open to revision and interpretation. And one month doesn’t make an investible trend anymore than a single swallow makes a spring.
But have you noticed? In the last month emerging stock markets such as China and Brazil have outperformed the U.S. market.
And that’s an absolute turnaround from results in 2010 and for most of 2011. Does it mean that we’re about to reverse the pattern that’s held for more than a year and see emerging markets start to outperform developed markets? Well, sort of. The picture right now shows that the outperformance is limited to some emerging markets and even in those markets, so far, the outperformance is spotty.
But I do think there’s the beginning of a trend here that your portfolio needs to respect. And since it’s so early, you need to pay attention to what kind of stocks in these emerging markets investors are willing to buy right now.
Here’s the data.
For the U.S. markets–for 2010 the Standard & Poor’s 500 stock index was up 15.02%. For 2011 to date, as of November 15, the S&P 500 was up 1.65%. In the last three months it gained 5.05% and for the last month 2.85%.
For Brazil—for 2010 the iShares MSCI Brazil Index ETF (EWZ) was up 7.69%. For 2011 to date as of November 15, it was down 19.54%. In the last three months the loss was a more modest 2.80% and in the last month the index climbed 4.35%.
Yep, after trailing for 2010. After getting killed in 2011 to date. After trailing badly over the last three months. In the last month the Brazil index beat the U.S. market.
China shows the same pattern—with some important wrinkles.
For China—for 2010 the SPDR S&P China Index ETF (GXC) was up 7.58%. For 2011 to date, as of November 15, it was down 11.31%. For the last three months the loss was 5.13%.
And in the last month the index climbed 4.77%.
In other words exactly the same pattern as Brazil—well behind the U.S. market until the last month. And then outperformance. And significant outperformance. We’re talking a 2.85% gain for the U.S. index versus 4.35% for Brazil and 4.77% for China.
One of the interesting wrinkles is that you could have done even better investing in China recently if you’d picked a different index. If instead of the SPDR S&P China with its 4.77% gain in the last month, you had invested in the iShares FTSE China 25 Index ETF (FXI), you would be looking at a 9% gain in the last month. (And a much lower 0.76% loss over the last three months too.)
What’s made the big difference in the gains from the two indexes? Size—in my opinion.
The average stock in the very concentrated FTSE China 25 Index has a market cap of $72.6 billion, according to Morningstar. These are huge companies—and indeed Morningstar categorized 92.4% of the index holdings as “giant.” (This isn’t exactly a surprise since the mandate of the index is to invest in the 25 largest Chinese companies listed in Hong Kong.)
The average stock in the SPDR S&P China Index isn’t a small cap by any means (although the index does include a 0.43% weighting of small cap stocks and even a 0.19% weighting of micro caps.) But the average holding is a smaller (if still very large) $27.7 billion. Only 61.2% of holdings qualify as giant, according to Morningstar. And the index even includes an 8.2% weighting to stocks that qualify as mid cap. (The index is a market cap weighted index of 130 tocks that trade in Hong Kong, or as U.S. listed ADRs, or are listed on the New York Stock Exchange.)
There’s isn’t a similar big and bigger index pair for Brazil—but comparing the gains of the iShares MSCI Brazil Index to that of the iShares MSCI Brazil Small Cap Index makes a similar point—size matters very much right now. In the month ended November 15 the small cap Brazilian index (average market cap of its holdings $776 million) showed a 2.28% gain to the 4.35% gain for the iShares MSCI Brazil index (average market cap of its holdings $21 billion.) Only 22.2% of that index is made up of mid-cap companies and a tiny 2.2% consists of small cap stocks.
Why the discrepancy between big cap and small cap performance in Brazil and China as these markets show signs of moving out of the downturn that has ruled them since they peaked back in November 2010?
A couple of factors explain it, I think.
First, the early cash flow moving into Brazil and China is dominated by institutional investors who 1) favor big stocks when they put money to work since they want to be able to deploy substantial cash without raising the price of the stock they’re buying (until they’re done buying) and who 2) want to make sure they can get out as easily as they got in. Think it might be easier to move in and out of Petrobras (PBR) with its $173 billion market cap and U.S. ADR or Kroton Educacional (KROT11.BZ) with its $968 million market cap and no U.S. listing? All else being equal—and of course it’s not when you’re comparing an oil company with a education company—size explains why Petrobras is up 8.9% in the last month and Kroton Educacional is down 0.06%.
Second, banks. Banks are overrepresented in the bigger cap indexes.
Financials aren’t always a leading sector when a stock market rallies, but I think they’re likely to be if China and Brazil are indeed headed for a period of outperformance. That’s because in the case of both of these markets, actual or anticipated interest rates cuts from central banks are a big part of the force behind these rallies. The Banco Central do Brasil has already started to reduce interest rates in order to get the economy moving faster—and economists anticipate another rate cut or maybe two in 2011. In China the People’s Bank is maybe as much as six months away from an interest rate cut—first, the central bank has to unwind a few of the nine increases in bank reserve requirements it put into place since October 2010, and second, it needs to be sure that the official inflation rate is actually headed below 5% on its way to the official target of 4%. But on the current trend interest rate cuts are on the way. Banks are an immediate beneficiary from rate cuts since they see the cost of the funds that they will lend out fall at the same time as the interest rates they charge borrowers remains high. Net interest spreads go up and that goes straight to the bottom line. Banks and other financial companies with investment portfolios also get an extra benefit—as assets prices go up in any market rally produced by those interest rate reductions, the value of the assets in those portfolios rises too.
Wednesday and Thursday’s big sell off in emerging market stocks was a reminder that these markets aren’t anything like a sure thing. For stocks to go up in China and Brazil, the level of fear in the financial markets doesn’t have to disappear but it has to be contained. If the euro crisis is just bubbling along threatening to engulf Greece—as has been the case for the last month—then I think Brazil and China can outperform. If the euro crisis ratchets up so that investors are worried about contagion reaching France, then I think everything goes down and emerging markets such as China and Brazil go down harder than the U.S. market. These financial markets remain more volatile than their developed economy counterparts. That’s great when the volatility is to the upside, but frightening when the volatility is to the downside.
I think the emerging outperformance of the emerging markets of Brazil and China is real. And I think you should be adding these stocks to your portfolio.
But we’re in for an extremely volatile couple of weeks as we wait for the European Central Bank to figure out that, like it or not, it is the buyer of last resort in the European sovereign debt market. And then don’t forget the volatility that results as we watch the U.S. Congress thrash around at funding the U.S. government—there’s a deadline for that on November 18—and at reducing the U.S. budget deficit—there’s a deadline for that on November 23.
When some of that storm has passed, I’ve got a candidate for the early stages of Brazilian outperformance already teed up in my watch list http://jubakpicks.com/watch-list/ . That’s big Brazilian bank Itau Unibanco (ITUB). And with this post I’m adding Chinese insurer Ping An (PNGAY in New York or 2318 in Hong Kong ) to my watch list.
Ping An was down 28.66% for 2011 to date as of November 15—but up 13.43% for the last month. Exactly the kind of pattern I’m looking for—but that I’m not quite ready to put in Jubak’s Picks. Yet.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Itau Unibanco and Ping An as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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