The Case Against Re-Emerging Markets

The Case Against Re-Emerging Markets

Brave Punditry

If you’re of a contrarian viewpoint you might cast your eyes across the pundit’s tips for the best performing sectors of 2010 – or, indeed, any year – with a slightly jaundiced eye. This year’s favourite flavour of investment is emerging markets. There are strong and powerful arguments in support of this particular long-term trend but you’ll rarely find the short-term value counterargument.

Counterarguments are critical for sensible value investors, because they force us to consider what could go wrong despite what our deceitful and biased brains are telling us. Any idiot can see what can go right – and, indeed, they spend a lot of time telling us about it – but putting a purely positive spin on any investing situation doesn’t come close to providing a sensible basis for allocating our valuable and scarce capital.

Re-emerging Markets

The first thing to remember about emerging markets – that subset of the world’s stockmarkets that are representative of economies which aren’t fully developed – is that most of them were in the same state a century ago. To be precise most emerging markets have already emerged at least once, had a good look around at the benefits of a developed economy and then promptly sunk back into oblivion out of some combination of political maladministration, war, famine or simple sheer bad luck.

You’d be hard pressed to detect this from the performance figures associated with these markets because most of the statistics about them reflect only the period since their re-emergence. Such is the nature of survivorship data that these not infrequent busts have been expunged from the records as though they never existed. Viewed from today’s vantage point the concept that these markets could once again collapse is hard to credit, but history suggests something different – that emerging markets are dangerous, delicately balanced affairs and the path of true capitalism rarely runs smooth.

To Lebanon and Beyond

Perhaps the greatest exponent of this concept is Nicolas Taleb whose experience of his home country, Lebanon, has been hugely influential in shaping his world view. Lebanon, oft-described as Switzerland on Mediterranean, was a country blessed with wonderful resources and a thousand year history of peaceful co-occupation by people of multiple religions and ethnicity. Then, in the 1970’s, it descended into a civil war that destroyed it and its economy and from which it’s still struggling to recover. As Taleb relates, many of the people displaced in the subsequent diaspora never accepted that the world had changed. Many spent the rest of their lives waiting for “normality” to re-assert itself.

Emerging markets are never a one-way bet but, to take the alternate view, it’s also worth pointing out that today’s biggest markets were once emerging in their own right. The USA spent most of the nineteenth century doing so, whilst undergoing a series of eye-watering debt defaults and stockmarket crashes. Even so, the spoils of such development often don’t go to investors: whereas in developed markets you’ll normally see your equity investments diluted by 2% to 3% a year as companies raise more capital, in emerging markets those figures may be as high as 20% to 30%. Believe the raw numbers if you will, but do so at your peril.

Value Investing in Emerging Markets

Performance within the range of emerging markets may be hugely varied as well, yet exhibits many of the same features as we see with standard investments. A Brandes Report on the value attributes of these markets finds that just as in developed markets both the worst performing stocks and the best performers end up mean reverting, only to a greater extent: the report suggests that from 1980 to 2007 the value premium – the excess return of value stocks over growth stocks – in emerging markets was 17%, over double that in non-US developed markets.

This, of course, poses a particular problem for most overseas investors engaging in these markets through the use of index trackers targeting large market capitalisation stocks – i.e. those stocks most likely to mean revert in the wrong direction. Although, as we shall see, even that’s probably better than trying to time your investments.

As the report points out, the overall performance of emerging markets over the past decade has been stunning but has largely been linked to the commodities boom which itself has been fuelled by the growth of China and India, two markets which appear to be emerging rather faster than others. We’ve seen such booms before and they’ve rarely ended happily for those countries in possession of the basic commodities: astonishingly typical constant-price GDP of an African non-agricultural commodity exporter appears to drop by 26% in the 25 years after a commodity boom.

The Growth of Liberal Democracy

It’s a remarkable fact that just over 200 years ago there were only three liberal democracies in existence – the USA, the UK and Switzerland. Since then over 70 countries have joined the club and, without exception, their economies have boomed, notwithstanding frequent busts along the way. However, the simple correlation that a liberal democratic political system leads to economic growth is, probably, perfectly wrong: get your economics right and the tax-paying middle classes eventually demand the representation that their contributions require. Wealth first, political freedom second is the rule: proponents of regime change need to develop stockmarkets, not democratic reforms.

If you fail to get your politics correct, however, then economic boom almost invariably leads to economic collapse. At the heart of the equation are property rights, because if people don’t get to keep the rewards of their industry and face the potential consequences of arbitrary confiscation by the state then the rationale for investing time and effort in business activities is destroyed. Incentives matter, even at the national level.

This isn't a question of the type of political doctrine; both left and right wing administrations have managed to wreck their underlying economies through various demented policies. Sometimes the destruction is visited upon economies from outside, sometimes from within. Sometimes regimes are changed by force, other times they implode under the weight of their own myopia – each collapse has its own pathology, traceable only in retrospect and unpredictable in advance.

Extreme Kurtosis

The politics of emerging markets, then, are peculiarly dangerous for investors. Yet not only do we have to manage the range of political issues but these markets are characterised by extreme behaviour, even more so than those of developed nations which, as we well know, can be frightening enough. Javier Estrada in Black Swans in Emerging Markets records:

"On average across all 16 markets, missing the best 10 days resulted in portfolios 69.3% less valuable than a passive investment; and avoiding the worst 10 days resulted in portfolios 337.1% more valuable than a passive investment. Given that 10 days represent 0.15% of the days considered in the average market, the odds against consistently successful market timing are staggering. Hence ... of the countless strategies that academics and practitioners have devised to generate alpha, market timing is one very unlikely to succeed."

These markets exhibit extreme volatility and, for the most part, their returns demonstrate severe levels of kurtosis, the fat-tails at the edges of the typical normal distribution of returns: things get extreme far more often than classical analyis would predict. Typical human behavioral biases seem to get exaggerated in these situations, just as in developed markets, but the nature of emerging markets appears to make this problem even worse, such that trying to time them is clearly nonsensical. If you can’t invest in value based vehicles and you have to be in these markets then being in them full-time is the only real option. Which, of course, brings us back to face the mean reversion issue discussed earlier.

There’s a secondary problem, identified by Bekaert and colleagues back in 1998 – that the process of a market moving from a developing to a developed state can itself lead to anomalous returns. The researchers point out that as a market changes in this way the marginal investor stops being a local and starts being a foreigner. This change can temporarily drive up returns only for them to drop back to a more normal distribution as the local index becomes more diversified. So excess gains from an emerging market may simply be a temporary phenomena due to a surge in liquidity.

Never Forget the Counterarguments

None of the foregoing means that there isn’t a bullish case for some emerging markets. The problem is that markets don’t emerge smoothly or linearly, but do so stutteringly with the ever-present possibility of failure. Following a decade in which developing markets have outperformed developed ones it’d be a brave person who bet that this would continue without some kind of setback, especially given the faltering nature of debt-laden western consumers and the continuing deflationary effects of adding the odd billion or so low-paid workers to the global economy.

Fortunately the world is full of brave pundits prepared to put our money on the line by telling us that these markets are a one way bet. Just as we’d be foolish not to have a small percentage of our investments in such markets we’d be equally so to be betting the farm on them. They're also situations where looking for value oriented investing vehicles may be safer than straightforward large cap index trackers.

These are the counterarguments: do with them what you will.


timarr