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Why Emerging Market Struggles Are Good for Your Portfolio

While the United States has rallied, emerging markets are tanking. And a dip over the last few days has put the MSCI Emerging Markets Index in the red.

Over the last 12 months, U.S. markets have rallied 10%. Emerging markets, on the other hand, have been down as much as 16% – and have barely fought back to breakeven.

The culprit? Some attribute it to earnings. The latest round of reports has shown an unusual number of the (more dependable) foreign companies reporting lackluster earnings and guidance.

And it’s not just small, risky stocks. Poland’s largest phone company, Telekomunikacja Polska (TKMGF) – a respectable dividend payer – plunged 45%. Mega-cap company, Gazprom OAO (OGZPY), is down nearly 9% since its earnings report.

So it’s true that earnings have, indeed, led to the sharp drop over the last week. But emerging markets have underperformed for the last year. Meaning there’s a bigger issue here.

Namely that America is an attractive investment again.

Think about what’s driven investors for the last few years. First, there was a fear of systemic risk. Markets were dominated by the risk-on/risk-off trade, and Treasuries were snapped up by scared investors.

Since this drove down Treasury rates, investors went on a chase for yield, plowing money into emerging markets – especially emerging markets debt. Take a look at the WisdomTree Emerging Markets Local Debt Fund (ELD) to see what I mean:

Ultimately, a fear of risk led investors to risky emerging markets investments. It sounds strange. But it actually makes sense, since the trend occurred during a time of increased pessimism about the western financial system.

There was the U.S. financial crisis, the debt ceiling debates, the election, potential European defaults, the euro crisis, LIBOR scandal… The list goes on.

Those fears made the risks attached to emerging markets seem tame and understandable.

Recall the examples of big declines I mentioned above – the Polish phone company and Gazprom. Both were big healthy dividend payers. That’s indicative of the kind of stock that these yield chasers would buy.

But that’s all changing now. Confidence is returning to the United States in a big way. Money is moving out of Treasuries and emerging markets, and flowing into U.S. stocks. And it’s happening in a way that will make this year a “game-changer.”

It also means that we’ll see a continued struggle for emerging markets, at least in the short term.

When you combine this sort of risk cycle with a few quarters of slow earnings, emerging markets will be undervalued in short order.

This prediction will be revised as new data comes in, but I suspect that in 9 to 12 months, it will be time to buy emerging markets on the cheap.

In the meantime, the good news is that falling emerging markets stocks translate into rising U.S. stocks for now. So enjoy.

Ahead of the tape,

Matthew Weinschenk

Matthew Weinschenk