NEW YORK (Fabian Capital Management) -- The recent strength in emerging market countries has caught many investors, including myself, by surprise.
There have surely been pockets of strength in thriving economies such as India and Taiwan, but the majority of broad-based emerging market indices have been unable to mount a convincing drive higher. Nearly every rally attempt has been met with resistance that has failed to gain momentum or produce a substantial breakout.
The recent flattening in the domestic markets along with shifts to defensive sectors such as utilities, long-term Treasury bonds, and consumer staples may be one reason for the gains in emerging markets. Value seeking growth investors might be finally starting to warm up to the idea that these economies offer a way to diversify outside of the United States and have a great deal of upside potential.
Emerging markets entered the year under heavy negative sentiment that has likely worked in their favor as well. Often when an asset class is most loathed or feared, it turns around its misfortunes and catches everyone off guard.
According to recent data from ETF.com, the iShares MSCI Emerging Market ETF(EEM) - Get Report has begun to see a jolt of inflows after months of investor redemptions. Through the first three months of the year, EEM lost $7.5 billion in total assets to pile on top of $5.3 billion it lost in 2013. However, this exchange-traded fund has already gained over $2.5 billion in new money during the first few days of April. That is a significant swing in asset flows in a very short period of time.
From a performance standpoint, EEM has posted a gain of 10% since the beginning of February compared to half that return in the SPDR S&P 500 ETF(SPY) - Get Report. An even wider divergence exists between emerging market equities and the iShares Russell 2000 ETF(IWM) - Get Report, which has come under significant pressure in recent weeks.
The real test for EEM is whether or not it will be able to push back above its 2013 high and extend these recent gains above the $44 level. If it fails to do so, many critics will point to out that these stocks likely just experienced an oversold bounce in the midst of another lackluster year.
The long-term opportunity for emerging markets right now is the combination of negative sentiment and underweight exposure that most investors have to these countries. If we do start to see additional momentum take hold, the effects of rebalancing and performance chasing by institutional and retail investors will likely provide a strong lift to these stocks for quite some time. Severely oversold regions such as the iShares MSCI Brazil ETF(EWZ) - Get Report and MarketVectors Russia ETF(RSX) - Get Report have a long way to go to make-up ground on their emerging market peers.
Right now, I do not have an allocation to emerging market equities and instead have been focused on fixed-income opportunities in these countries. However, I am closely watching and considering adding to a tactical holding such as the SPDR S&P Emerging Markets Small Cap ETF(EWX) - Get Report when the opportunity presents itself. Emerging market small-cap stocks have held up better over the last several years than large-cap equities. In addition, the top three country holdings in EWX are Taiwan, China and India, which have performed better than their peer group.
In my opinion, emerging markets should be back on your watch list and included in strategizing your portfolio game plan. While they may still be susceptible to periods of volatility, they may end up surprising us with additional upside in the coming months as long as the global economy holds up.
In addition, shifting equity flows may enhance market leadership as dynamics change. To guard against a reversal of fortune and define your risk, consider using a stop loss or other sell discipline as a precautionary measure.
At the time of publication the author had no position in any of the stocks mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.