Emerging Markets Not Part of Stocks' Rally

NEW YORK ( TheStreet) -- Investors with long-term time horizons tend to look at stock exposure in emerging markets as a guaranteed win. But when we look at this year's conspicuous underperformance in the BRICs benchmarks (in Brazil, Russia, India, and China), it starts to become clear that those investing in these regions need to exercise conservative caution.

When we look at most financial headlines, optimism continues to be the central theme. Stock benchmarks in many developed nations have shown double-digit growth on the year, with the S&P 500 and Dow Jones Industrials gaining more than 20%. Even in Spain (a nation with unemployment rates above 26%), the Ibex has moved higher by nearly 4%.

Stock values in emerging markets, however, show an almost reverse image of this positive outlook: Brazil's Bovespa has dropped by more than 20%, the Shanghai Composite Index (SHCOMP) has fallen by 9.8%, and the broader iShares MSCI Emerging Markets Index ETF ( EEM) is now showing losses of more than 11%.

When we look at the net worth of positions held by those invested in assets tied to the SHCOMP, we see losses of nearly three-quarters of a trillion dollars relative to the highs seen in 2009. These trends show that the days of easy buy-and-hold strategies for emerging market investments are behind us, and that continued outperformance in developed markets should be expected.

China Weakness

Some of the most striking signs of weakness can be seen in China. Prior rallies in the SHCOMP were generated by massive stimulus programs, which pumped more than $650 billion into new construction in railways, housing, and roads. Since hitting its peak in 2009, the index has fallen over 40%. At the same time, the S&P 500 has regained all of the losses posted after the credit crunch in 2008 and continues to push new record highs. And when we look at the macro picture, there is little to suggest these trends will end any time soon.

China is now set to grow at its weakest rate of expansion since 1990 as government imposed restrictions will require 1,400 factories to be closed in an effort to phase out obsolete and excess production capacity. In 2009, five Chinese companies ranked in the top 10 world's largest firms by market value. Last month, no Chinese companies were on that list. Stated goals for the Communist Party show a clear intention to rein in the nearly $2 trillion lending boom that started in 2009, which created bubble-like housing prices and record debt liabilities for local governments.

Longer term, the plan is to move the country from its reliance on foreign exports and managed currency values to an economic position that is more sustainable -- led by services and domestic consumption.

But this transition will not be an easy one. There is little reason to believe investors will drive a broad-based reversal in the country's depressed stock values any time soon. The SHCOMP now trades below 11 times earnings, a major drop from the 29 multiple that was seen during the 2009 peak. This is also when the index was trading at a 60% premium relative to the S&P 500. The SHCOMP is now 35% cheaper than the U.S. benchmark and, at this stage, it looks as though the long-term trend will be characterized by strength in the stock markets of developed nations, with prolonged weakness in China and its BRIC counterparts.

The leadership in China has been most vocal about its willingness to accept slower rates of growth. But this is a reality that emerging markets as a whole will have to face in coming quarters. This means investments in emerging markets will continue to pose added risks when we look at global stocks on a comparative basis.

At the time of publication the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
Richard Cox is based in China, and has lectured at several universities there on international trade and finance, focusing primarily on macroeconomics and price behavior in equity markets. His articles appear on a variety of Web sites, including MarketBulls.net, Seeking Alpha, FX Street and others. Investing strategies are based on technical and fundamental analysis of all the major asset classes (stock indices, currencies, and commodities). Trade ideas are generally based on time horizons of one to six months.

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