EC When Bond Kings Short Emerging Market Equities -

EC When Bond Kings Short Emerging Market Equities

Mar 11, 2016Jeremy ParkinsonFinance0

“If you’re going to do something in emerging market equities, my recommendation is to short them. They may fall a further 40%.” – JJ

Jeff Gundlach hates Emerging Markets. So does almost every other pundit on financial TV. So do the rating agencies. Can you blame them?

Over the past five years (through February), while the S&P 500 has nearly doubled (+98.4%), the MSCI Emerging Markets Index is down 6.6%.

The performance spread (over 100%) is the widest since the late 1990s. (Note: after which Emerging Markets would go on to outperform until late 2007.)

Statistically, it would seem that there is no reason for U.S. investors to take on additional risk here in Emerging Market equities. We have data on EM going back to 1988. Since then, EM has underperformed the U.S. (9.3% annualized vs. 10% annualized) with significantly higher volatility (23% vs. 14%).

Lower returns and higher volatility. Why in the world would anyone want that?

Fair question. But investing is about the future, not the past. Simply picking the asset class with the highest recent return and lowest volatility has not generally been an effective strategy for long-term investment success.

The fact that EM has significantly underperformed the U.S. and is down over the past five years is actually a good thing for those considering diversifying into the asset class today for two reasons:

1) It means increased odds of higher prospective returns (long-term returns are highly correlated with beginning valuations which are more favorable today in EM than the U.S.), and

2) It means that EM can add diversification benefits through lower correlation (because EM does not move in lockstep with the U.S., it can be additive to a portfolio over time).

But what about the new Bond King?

Right, Mr. Gundlach is telling you to short Emerging Markets. Since he has been crowned the new bond king, no one asks if he himself is doing so (doubtful), and why a prediction of a 40% decline is coming after, not before, a five-year bear market that has taken Emerging Markets equities down 43%.