When asked why his views shifted so frequently, the legendary economist John Maynard Keynes retorted: When facts change, I change my mind. What do you do, Sir? It was probably such a flexible mindset that made Keynes one of the few economists who was able to convert economic theories into profitable investment strategies. In the investment game, it is terribly important to allow opinions to evolve. This is particularly relevant in the current environment as these are exceptional times. Many asset classes are experiencing their strongest runs ever and are in uncharted territory. Financial analysts are all atwitter on how to approach the new game. The impulsive reaction is to dub the surge as irrational and say it cant last. Reversion to the mean is the default thought process. While that may be the best way to think about investing in the very long-term, intermediate trends are often dictated by paradigm shifts. With a mean reversion strategy, the right time horizon is also an issue. For example, commodity prices are witnessing parabolic moves and trading well above the average levels of the past two decades. From a 200-year perspective though, commodity prices are still well below the mean. Similarly, even though emerging markets have massively outperformed US equities since the end of 2002, it was only a few months ago that they overtook the US market in terms of total returns generated since their conception as an asset class in 1987. In fact, emerging markets would have to outperform US equities some more despite their current elevated levels to compensate for the extra risk investors have taken for investing in this area for the past 19 years. Furthermore, bull markets culminate in significant deviations from the mean and in excessive valuations. The mega 18-year US bull market began in 1982 with the Price-Earnings (P/E) ratio of the benchmark S&P500 index trading at eight times forward earnings and ended in March 2000 with the S&Ps P/E ratio at 25. Over the past hundred years, the average forward P/E for the S&P has been 14 and it has only now returned to that valuation. Emerging markets could well be in the midst of such a powerful bull market, driven by the paradigm shift in the macro and micro fundamentals in many developing countries. Thats why the history of emerging markets from the past decade en the asset class was viewed as a cyclical play that ebbs and flows with the global growth momentum isnt the correct view now. The US market was re-rated in the nineties and this decade emerging markets will likely be re-rated as more of a secular growth story. Compared to the nineties, there are already signs of a role reversal between emerging markets and the US. Back then the United States was in a heady bull market tested at times by troubles in the developing world. The Asian financial crisis in late 1997 and the Russian debt default drama in the third quarter of 1998 triggered corrections in the US. Now, the biggest risks to emerging markets are external, ranging from the Federal Reserve raising rates in an overheated US housing market to the possible contagion from financial vulnerabilities of smaller developed countries such as Iceland and New Zealand. It is particularly worthwhile to note that unlike in the past when developing countries were most affected by tightening liquidity conditions, the Feds rate-hiking spree has so far worst hit Iceland and New Zealand. Currencies in both these countries have fallen sharply this year as capital has flown out, leaving large current account deficits badly exposed. In contrast to a decade ago, developing countries in aggregate have a current account surplus to show. Even the few emerging markets, which have a current account deficit have a robust external position, due to strong support provided by portfolio inflows. Inflows to emerging markets are gushing in at levels way above the past. Dedicated emerging market equity funds have attracted more than $30 billion in net inflows this year, already surpassing record inflows of $25 billion for all of 2005. Moreover, many global funds are increasingly investing in emerging markets. Its tempting to be wary of such a pick-up in activity and to consider it a sign of too much exuberance. After all, the last major emerging market bull phase ended in 1994 amid extremely aggressive foreign buying, with Japanese coming in at the fag end of the cycle. As a result, a widely cited saying in the investment world is: When the Japanese buy, its time to sell. However, clichés dont work in the investment world. If most market participants view the buying habits of Japanese investors as a signal to sell, it means thats no longer a relevant sentiment indicator. The investing game keeps evolving through continuous and subtle changes. The bull-run in emerging markets will be near an end when all the old rules are forgotten and new ones are established which indicate this is truly a new era for the asset class. For the time being, the operating assumption needs to be that emerging markets are still in the middle of a longterm up-trend. Along the way, there will be corrections, just like the US market experienced in its 18-year secular run. Indeed, two painful bear markets the 1987 stock market crash and the 1990 recession punctuated that mega bull trend. Emerging markets, too, will be tossed around by such storms. Such deep corrections are likely to materialise only when people least expect it. The surprise decision by the Chinese authorities to raise interest rates last Thursday is indeed causing some anxiety. But the markets have been resilient so far. The corrections are getting shallower and shorter as there is still a healthy dose of caution in the marketplace. Source: ET

Posted by toughiee on Tuesday, May 02, 2006 at 5:38 PM | Permalink