Normally, a rotation from high-flying momentum names into beaten-down value stocks is a sign that investors are shifting into “risk off” mode and getting defensive.
But what if those “beaten-down value stocks” happen to be in emerging markets?
It’s hard to argue that the March breakdown in glamour names like Tesla Motors (TSLA), Netflix (NFLX),Twitter (TWTR) and the biotech sector (IBB) is a sign that investors are getting jittery about risk when emerging markets—and specifically the emerging markets viewed as being the weakest or most exposed to geopolitical risk—have gone on a massive run.
Take a look at the chart above. I graphed the performance since March 1 of some of the most popular momentum stocks against a basket of “problem children” emerging market ETFs—the iShares China Large Cap ETF (FXI), iShares MSCI Brazil (EWZ), Market Vectors Russia ETF (RSX), iShares MSCI Turkey ETF (TUR) and iShares MSCI South Africa ETF (EZA).
The bottom section of the graph illustrates the relative performance of each of these ETFs vs. Tesla. Over the past five weeks, TUR and EWZ have outperformed Tesla by 42.0% and 35.8%, respectively. Even Russia, in the midst of its Crimean intervention and Western sanctions, outperformed by 19.2%.
What’s going on here?
The answer is simple. As Warren Buffett famously said, in the short term the market is a voting machine, but over the long term it is a weighing machine. Given time, money will flow to the sectors that are priced best to deliver solid, long-term returns. And that is exactly the case with most emerging markets today.
Russian stocks trade at a cyclically-adjusted P/E (“CAPE”) of just 6, making Russia the cheapest market in the world after Greece. Brazil trades at a CAPE of just 10, and Turkey and China just 12. South Africa is comparatively expensive, at a CAPE of 20. But even this is significantly cheaper than the U.S. markets, which are valued at a CAPE of over 25.
Meanwhile, let’s take a look at the momentum names. Tesla has no earnings at all, though it trades at a market cap that values the company at roughly half the value of General Motors (GM)—and this despite the fact that GM sells more cars in a weekend than Tesla sells in a year. Netflix—while profitable—trades at a CAPE of about 152. You could reasonably argue that a metric like CAPE, which uses a trailing 10 years of earnings, is meaningless for a high-growth company like Netflix. But this is still a company with a modest 3.0% return on equity that trades at 47 times forward earnings.
Twitter? Twitter has no earnings but trades for 36 times sales. That’s expensive on a 1999-tech-stock level for a company that has yet to establish a viable profit model.
Plenty of smart investors put substantial sums of money into the new technology momentum stories of 2013 and did very well. There is absolutely nothing wrong with jumping on a hot momentum stock, even one that is priced at unjustifiable bubble levels. Just don’t stick around too long because a trickle of selling can quickly turn into a rush for the door.
The question to ask yourself now is, “where will the hot money flow next?”
My bet is emerging markets. Even after the recent run, prices are cheap across the sector. And emerging markets are underowned, both by professional investors and individual investors. Prior to last week, emerging market funds had seen 22 consecutive weeks of outflows. These are the conditions you like to see in place before a major, multi-year bull market.
My recommendation? Don’t try to buy Tesla, Netflix or Twitter on dips. These are yesterday’s trade. Allocate the speculative portion of your portfolio to emerging markets.
Disclosures: long TUR, EZA, RSX, FXI
