Emerging Markets Aren't a 'Buy and Hold' Asset Class

Investors have learned the hard way that emerging market equities can be dangerous. The conventional wisdom that said they must be "diversified" ran aground amid the 2008 banking crisis as emerging markets declined even faster and further than developed economy equities. In fact, investors have come to realize that emerging markets or BRICs (Brazil, Russia, India and China) are not even a coherent investable asset class.

The term emerging market is a political distinction, not an investment one. It describes very loosely a heterogeneous collection of countries as diverse as China and Turkey. These countries and their economies are called ‘emerging' because they lack the institutions of law and equity that we rely on in more developed western economies.

As a group these stocks do well under one condition - a weak U.S. dollar. Under a weak dollar these emerging market countries, many of which export commodities as do Brazil and Russia, prosper and experience capital inflows. This was the case from 2003 through 2007 when weak U.S. dollar policies that began in 2000 caused emerging stock markets to vastly outperform U.S. markets. As the chart below shows, an ETF of emerging stock markets (EEM) dramatically outperformed the S&P 500 from 2003 through 2007. (see chart below)

Things changed in 2008. As investors painfully learned in 1998, sudden changes in the value of the U.S. dollar can collapse fragile emerging economies. Remember the 1997-98 Asian Tigers' crisis and the collapse of Russia? As the next chart shows, history repeated itself in 2008 when emerging markets provided no diversification. Post crisis, since 2010, emerging markets have failed to return to their early 2000s glory. They have been largely ‘dead money' while U.S. and other developed markets advanced. This trend accelerated in 2013, a year in which the dollar and Euro currencies dramatically strengthened; causing pain for emerging market investors. (see chart below)

One notable country that has experience the pain of a stronger US dollar is Russia. Russia's stock market has fallen roughly 40% since 2011, the year in which gold prices peaked at $1,900/oz. Converseley, the U.S. stock market is up 65% over the same time period. The Russian stock market's dismal performance is a symptom of economic distress that is not a surprise in a strong dollar world. (see chart below)

Bottom line: Investors can own emerging market assets, but they must know why and when to do so. Emerging markets are not a ‘buy and hold' asset class and most should only be considered in periods of sustained U.S. dollar weakness.

James Juliano & Russell Redenbaugh are partners at Kairos Capital Advisors.