Buyer Beware

I had a conversation with an portfolio manager months ago but the relative performance of the emerging markets to the S&P 500. My argument was simple: the emerging market trade was overdone and a correction relative to the S&P was probably going to play out based on a stronger dollar and some mean reversion in the relative performance of the two indexes - a game that the emerging markets have won handily over the past 10 years. Over the past month though the game seems to be getting a bit more interesting. As the chart shows, the emerging markets index by itself is in breakout mode - but relative to the S&P, it sits well below previous highs which in a way is considered a "negative divergence." There is no doubt that the global growth opportunities sit in the emerging markets at the moment and simultaneously, the US is finding PE compression the norm even in the face of strong corporate balance sheets.

So what to make of this chart? Bullish or bearish? Well, lets add one more variable; inflows into emerging market ETFs. According to a recent report, emerging market ETFs are taking in so much more assets than comparable ETFs (and large cap domestic is showing huge outflows...). So everyone is running away from the US and investing overseas in what is termed the likes of the BRIC. The problem with the current move is that it is not grounded in the index itself but the weakness of the S&P and the fact that the dollar has come off and not turned to the upside in any sustainable way (one month does not make at trend). This essentially means that variables outside of the emerging markets are pushing them upward which is not sustainable. Sure the dollar could go into a multimonth or year downtrend again or the S&P 500 could suffer another flash crash (which I think is not in the cards) while the emerging markets index does nothing.

In other words, I think based on the fast money moving into these markets, the recent dollar behaviour to the upside and the renewed uptrend in the S&P, the emerging markets might be in for a world of hurt if these flows reverse.

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