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Stock Market Mystery Or Everyday Behavior?

The Economist writes today about the mystery of emerging market stock performance. Since emerging markets are believed to be more sensitive to the global economy, many people think they should be doing very well since other markets have had big increases already this year. Instead they are down by over 4% while the global market is up by over 6%.

The mystery is played up with a research note from a big bank that goes into detail on eight reasons for the underperformance. While some of these would be very good reasons for the difference, there is another simpler explanation: emerging market stock prices have gotten ahead of themselves over the last year (or the last few years) while other markets have been held back by bad news, and now investors are repositioning. Stock market activity happens in bursts as much as it does in a smooth progression, so we may have gotten emerging market gains last year and developed market gains this year. This kind of thing seems to be a very common pattern.

The fact that many investors believe emerging markets act as a more extreme version of developed markets may be exactly why they didn’t. Whenever we get to the point of maximum investor belief in any idea, the opposite turns out to be true as some investors lose faith in it and reverse their decisions. This is unpredictable because we never know how many believe it takes to reach the maximum. It can happen in small waves that come and go frequently or the occasional big bang that turns the market upside down. There is no mystery in this, and it’s a good reason to focus on several different asset classes and avoid the ones that have done well recently.

In fact this highlights another useful thing: despite all the talk about correlations rising, we are seeing what we should see here. Emerging markets should not be perfectly correlated with developed markets which means that things like this are expected. The rise of global trade means that many companies around the world are influenced by the same factors, but they still typically have an exposure to local and regional events. That’s why there is still reason to believe that major markets such as the Canadian, US, European, and emerging indexes will not always do the same thing.

Since we have just started buying into emerging markets through the VXUS ETF, it’s exciting to see that they are getting cheaper at the same time that other holdings are rising quickly. If this trend continues it might be worth adding a bit into VWO to increase the weight of emerging markets. Currently I’m leaning in the opposite direction though, and considering putting a bit into VEA since the emerging market component in VXUS is a bit more than we want.

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