If You Are Thinking of Investing in Emerging Markets, Here's What You Need to Know

One of the hottest investment strategy themes over the past few years has been to invest in emerging markets. For years, these markets were very attractive to investors, as these economies tended to have much higher growth rates when compared to growth in the developed countries.

However, this investment strategy is now beginning to look questionable, as it appears that growth rates are much lower than many had expected.

The latest look at emerging markets from a fundamental standpoint comes from Paul Polman, CEO of Unilever PLC UL.

Polman stated that he believes that economically, these markets will continue to remain quite slow for some time, as these nations now need significant structural changes following their boom years. (Source: Bloomberg, December 2, 2013.)

Also Read: NYSE Holidays 2014

This type of information is certainly a negative for any long-term investment strategy in the emerging markets. Structural reforms do not happen overnight; here in America, it’s obvious how slow and difficult it is to make any real structural changes.

For many, the investment strategy in emerging markets appears enticing because it seems so exotic. But comments such as those from the CEO of Unilever should be an eye-opener to these investors. Unilever obtains most of its revenue from emerging markets, so the company can feel the pulse of what’s really happening on the ground in these markets.

Frankly speaking, this isn’t a surprise to me; in these pages, I’ve mentioned seeing several warning signs that have alerted me to the weakness in not only the domestic economy, but the emerging markets as well.

Chart courtesy of www.StockCharts.com

The three-year chart above shows the activity of the exchange-traded fund (ETF) iShares MSCI Emerging Markets EEM compared to the activity in the price of copper (as indicated by the solid black line).

As you can see, the price of copper and the activity in the emerging markets were extremely correlated up until the end of 2012. In 2013, copper prices continued selling off, while these markets began to rebound.

I believe this divergence is a result of money printing allowing institutions the ability to allocate capital into the emerging markets, even though fundamental drivers, such as copper, are indicating that these economies are not accelerating.

In my experience, this type of divergence doesn’t last forever. The latest information from the CEO of a company that has extensive operations in emerging markets globally has, yet again, increased my worry that the current move in many stock markets around the world is not based on fundamental strength.

Chart courtesy of www.StockCharts.com

More specific to the emerging markets, this chart shows the iShares Emerging Markets ETF against an inverse ETF, the Direxion Daily Emerging Markets Bear 3X Shares EDZ.

As you can see, the inverse ETF moves in the opposite direction of the ETFs that mimics the emerging markets. A note of caution: the inverse ETF is three-times leveraged, which means it can be extremely volatile and should not be a long-term holding. Highly leveraged ETFs will erode over time, so they should only be used as a hedge over a short holding period.

I continue to favor an investment strategy that reallocates capital away from sectors that are not showing fundamental strength. Emerging markets, in my opinion, still remain fragile; if I had exposure to that sector, I would certainly look to add a very small portion of capital into an instrument that can hedge my risks.

The big picture is that while all stock markets keep moving higher, executives at companies such as Unilever remain extremely cautious and continue to wave warning flags. At some point, fundamentals will matter and having an investment strategy that is diversified and partially hedged will pay off over the long run.

This article If You Are Thinking of Investing in Emerging Markets, Here’s What You Need to Know was originally published at Investment Contrarians