Time to Buy the Emerging Markets?

With the S&P 500 continuing its relentless drive higher, investors are struggling to add new money to large cap U.S. stocks.

Most agree that the longer term outlook for stocks remains positive. Interest rates will probably not be significantly higher for at least the next couple of years, regardless of who is chosen as the new Fed Chairman.*

Quarterly earning reports have also been generally favorable. According to Tania Harsono-Cloney of Bernstein, as of last Friday, 50% of the companies in the S&P 500 have reported earnings.  Almost three-quarters of those reports have beaten Wall Street earnings expectations, and 55% of beaten revenue expectations.

However, with the S&P 500 up nearly +20% year-to-date, many investors have this gnawing feeling that the market is well overdue for a correction.

As I pointed out last week, the S&P is +50% over the last three years, while the stocks of the emerging markets are off -4%.  Sentiment on the group is mostly bearish; the strategists that were wildly optimistic on the markets of Brazil, Russia, India and China a few years ago have disappeared from the scene.

Strategist Michael Hartnett of Merrill Lynch has been suggesting that investors consider an allocation to the emerging markets for at least a trade.  Hartnett points out that any time sentiment is so widely bearish on a sector, any kind of positive surprise can spark a strong rally.

The Vanguard Emerging Markets Exchange-Traded Fund (ETF) is a good proxy for the emerging markets.  More than 70% of the value of this ETF (ticker: VWO) is comprised of China; Brazil; Taiwan; South Africa; India; and Russia. I have posted the price action of VWO above.

While I am not a technician, I do believe that sometimes charts can present an interesting story.  I have circled two sharp price drops that have occurred in VWO over the past three years: one in early October 2011, and the other in June 2013.

The sell-off in 2011 is interesting because it occurred at at time when the U.S. markets were just starting to rally.  Note too that the price decline was accompanied by a spike in trading volume; investors were selling in droves.

However, VWO quickly recovered, and by the end of October the ETF had jumped by +25% in a month.

Now look at the sell-off from last month.  The same market action:  a sharp decline on large volume.  Could we see another sharp rise in the next few weeks?

The stocks in VWO are trading a significant valuation discount to the U.S. market despite significantly stronger growth rates. VWO trades at slightly less than 13x P/E ratio, and sports a 2.5% dividend yield, compared the 17x P/E of the S&P 500 and 2% dividend.

For the intrepid trader, I would think hard about playing VWO for a trade until Labor Day.  While the trade is not without risk, if the past is any guide, the emerging markets stocks are poised for a bounce.

*What if Ben Bernanke decides that he would rather stay on as Fed Chairman?