#$cew

"If you're going to do something in emerging market equities, my recommendation is to short them. They may fall a further 40%." – Jeff Gundlach, January 25, 2016

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%.

But I digress.

I don’t know what will happen for the remainder of 2016; no one does.  As I've been writing on twitter over the past month, though, I do find it interesting that:

1) Emerging Market credit has been leading to the upside and held up extremely well at the February lows.

2) Emerging Market Currencies are positive YTD and posting their strongest move to the upside in some time.

3) The two cheapest and most hated Emerging Markets, Brazil and Russia (see Meb Faber's recent piece on Global Valuations), are both positive YTD and outperforming U.S. equities.

Perhaps Gundlach will be correct and Emerging Markets will decline another 40% from his call in January. However, if one is an asset allocator looking out over the next five to seven years, I’d say the odds are quite high that Emerging Markets will handily outperform the average bond fund. Bond math is quite simple: low yield = low forward returns, as I wrote about last year (“Bond Math and the Elephant in the Room”).  Will there be volatility in Emerging Markets between now and then? You can count on it, which is the price of admission when it comes to investing.

If long-term investors are thinking rationally, perhaps the greater fear today should not be in the Emerging Markets where they likely have little to no exposure to, but in the bond portion of their portfolio. How do they expect to meet their retirement goals with a yield of around 2% in the average bond fund and Treasury Bills yielding less than 1%? How do they expect to close the gap between their lofty return expectations and the reality of low yields. There’s no easy answer to this question but I’d venture to guess that shorting Emerging Markets today (and getting that timing right on covering this short) is not likely to close that gap.

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Related:

Is it Time For U.S. Investors to Look Abroad

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of four award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors and previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

The fairytale told in early 2015 was that a collapse in the price of Crude Oil and other commodities was going to be huge boon for the U.S. consumer, the economy, and the financial markets.

In the past month, as we have witnessed multi-year lows across the commodity space, the story seems to have changed. The decline in commodities is now being viewed as a harbinger of a slowing global economy, wreaking havoc on financial markets.

What did the Pollyannish forecasts at the start of the year miss?

1) The impact of declining commodity prices on S&P 500 earnings, which have now declined (YoY) in each of the last four quarters.

2) The impact of declining commodity prices on the credit markets, particularly at the lower end of the credit spectrum.

-CCC high yield bond spreads are at their widest level since 2009.

-Distressed Bonds have lost more than half of their value since their peak in 2014.

3) The impact of declining commodity prices on the currency markets, particularly in Emerging Markets.

Capitulation?

Capitulation is defined as the action of surrendering or ceasing to resist an opponent or demand. In investing, capitulation is a good thing as it often coincides with a wave of selling near the end of a decline.

The challenge is in differentiating between capitulation that marks a short-term bottom from one that marks a cyclical or secular low. Unfortunately, there is no easy rule to follow.

There are some real signs of real capitulation today in the commodities market. Fears of further declines are heightened and most seem to be in agreement that these declines will negatively impact financial markets. This is a very different picture than the start of the year when the consensus view was overwhelmingly sanguine.

The question for investors is whether stocks and bonds, which are supposed to be forward-looking, are already discounting a further collapse in Crude Oil and commodities.

The bullish spin: the market is already pricing in a default cycle from the commodities crash and any stabilization in commodities from here will act as a positive surprise. The collapse in commodities is not indicative of a demand issue and the U.S. will not be pulled into recession any time soon.

The bearish spin: financial markets have only just started to appreciate the dramatic impact of the commodity collapse and if it is indeed signaling a global recession, further declines will follow.

To sign up for our free newsletter, click here.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of three award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors  and previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.