Follow The Smart Money Out Of This Hot Sector

David Goodboy's picture

Tuesday, November 22, 2016 - 9:30am

by David Goodboy

The economic cycles have turned negative on this attractive investment sector. Despite this sector having at one time been up by more than 16% this year, the signals are flashing that it is time to take profits. In fact, the primary ETF in the sector recently suffered its worst day of capital outflows since 2011. While at the same time, the bond-based ETF of this sector experienced $300 million in outflows, the most ever on record.

A Bloomberg analyst stated that we could see $20 billion of outflows from this sector by November 18th.  Apparently, big money has announced its intentions. 

Despite the bearish signals, the mainstream financial press is alive with articles attempting to prop up the sector. The question is, will you continue plowing money into the "hot" sector of 2016, or heed the warning signs? 

First, let's take a quick look at the nature of financial cycles.

Most every investor knows that the market often acts in cycles. However, investors often ignore the fact that hot stocks -- or even sectors -- will not stay hot forever. 

Take the Internet bubble, for example. It was very clear that shares of untested, and often revenue-less, companies could not just keep moving higher. One day, the upward cycle would simply have to turn lower, taking trillions of investor's capital with it. And yet investors kept throwing their money at these new companies.

In fact, many stock market experts and pundits continued to preach the bullish mantra as the internet ship was sinking in the storm. 

The market bubble I'm talking about today is the uptrend in the primary emerging market sector. This sector was super-hot in 2016 with its leading ETF iShares MSCI Emerging Markets (NYSE: EEM) currently higher by over 7% year to date, despite the recent sell-off.  

There are three primary reasons why emerging markets have been hot in 2016.  First, a dovish Federal Reserve resulted in emerging market currency climbing. Second, Asian purchasing manager’s indexes signaled economic expansion by moving above the 50 level.  Finally, commodity prices climbed just enough to help commodity exporting emerging markets, yet not quite enough to hurt commodity importing markets such as Asia.

But it's not just the iShares ETF being hurt by the cyclical change. Bloomberg Barclays EM USD Aggregate index gave back nearly 2% of total return between November 9 and November 10.   

In addition to the performance of these funds, there are three reasons for my emerging market bearishness.

Capital Outflows From Emerging Market Stocks And Bonds
It is important to note that capital flows have historically reflected returns. This suggests that if the negative Treasury momentum persists, the pace of outflows could increase over the coming weeks, per Barclay Capital Credit Services analysts.

The record and near-record capital outflows of the emerging market ETF products can only be signaling an aggressive repositioning of assets by big money players.

Trump's Protectionist Economic Policy Plans 
Emerging markets are extremely dependent upon the United States to purchase their products and services. Despite China being a global exporter, the proposed U.S. trade barriers will significantly increase China's cost overall. Trump mentioned implementing 45% tariffs on Chinese imports and 35% tariffs on U.S. firms that outsource to China.

Barings Bank director of emerging markets believes this could lead to a trade war, saying "The global supply chain, which is highly interconnected in the IT and automotive industries, would also suffer greatly and is already facing disruption after the Brexit vote in the UK. At this point we should note that trade policy can be changed by executive order -- an intransigent Congress may not be able to intervene. If we do find ourselves in a trade war, Chinese authorities would likely act to stimulate demand, but the Chinese equity market, which has performed well in recent months, could become increasingly volatile."

A Stronger Greenback
Interest rates are nearly sure to start climbing higher very soon. Higher interest rates will strengthen the U.S. dollar, which in turn will make emerging market debt harder to repay.  Emerging market borrowing has doubled over the last five years to $4.5 trillion per the International Monetary Fund. 

At the same time, a strong greenback erodes the value of the emerging market’s currency so when a foreign investor wishes to convert their profits back into U.S. dollars, the conversion eats away at the gains, making emerging market stocks less desirable.  

Risks To Consider: No one knows for certain what the future holds. Should the economic expectations change, it could easily modify the investment thesis. 

Action To Take: Take profits from emerging market investments.

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David Goodboy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.