Why Emerging Markets will Finally Soar in 2014

It has been a terrific year for U.S. stocks.

If the Santa Claus rally kicks in, and the S&P 500 ends the year above 1,834, the year 2013 will end as the best one for the market since 1998.

In contrast, it has been all doom and gloom for emerging markets.

Even as the U.S. market has put the permabears in investors’ doghouses, emerging markets are likely to finish the year down 6%, compared with a (so far) 27% gain for U.S. markets and 19% for the rest of the developed world.

Having lagged the S&P 500 for over two years, emerging markets are coming off of their longest underperformance in recent memory.

So if you’ve put all of your eggs in the U.S. stock market basket, pat yourself on the back.

But for the rest of us who followed the textbook mantra of global diversification, putting money into almost any emerging market over the past two years has equated with rather embarrassing underperformance.

As someone who expected emerging markets to rally in 2013, the poor performance of emerging markets has left me scratching my head — and with egg on my face.

Despite this, I am going to stick to my long-term prediction that emerging markets are overdue for a monster rally — one that could see them rise 20%, 30% or even 40% over the coming 12 to 18 months.

How Emerging Markets Turned Into Submerging Markets

It used to be you could swing a cat on any Wall Street trading floor and hit an emerging market that was up by double-digit percentages, year after year.

Fast forward to today, and the emerging markets hardly look like the land of milk and honey.

Among the 40 global markets I follow on a daily basis, I can’t find a single emerging market up double-digit percentages in 2013 — unless you throw Israel into the mix.

Two of the four BRIC countries — commodities-dependent Brazil and Russia — are down by at least 25%. Former emerging market all-stars Turkey and Indonesia also matched this dismal performance.

Jim O’Neill — the Goldman Sachs economist who coined the term “BRICs” for Brazil, Russia, India and China a decade ago — has now left the venerable investment bank to spend more time with his family. You may have also noticed that the newsletters urging you to make your fortune from the “China Miracle” have disappeared from your email inbox. And I’m betting the days of the annual BRIC conferences where their leaders play up to a fawning global media are numbered as well.

Today, the term “BRICs” has been replaced by a new, less-flattering moniker by the Economist magazine — the “Fragile Five” — Indonesia, India, South Africa, Turkey and Brazil.

I think it’s particularly ironic that the “Fragile Five” includes two of the BRICs. And it takes no great stretch of the imagination to add emerging markets bad boy Russia or China to the list.

How Emerging Markets Went From Hero to Zero

There are a handful of explanations for the lousy returns in emerging markets over the past two years.

First, a technical point: the mainstream emerging markets indexes, like the MSCI Emerging Markets index, are heavily weighted toward the formerly red-hot BRICs. Today, China makes up 19.38% of the index, followed by Brazil, 11.64%, Russia, 6.20%, and India, 5.85%, for a total of 43.07%. The lousy performance of each these markets has essentially mirrored the entire emerging markets sector.

Second, average economic growth in emerging markets dropped to 4.5% by the middle of 2013. With the U.S. economy expanding by 4.1% in Q3, the gap between the United States and emerging markets has narrowed considerably. That’s a big change from only two years ago, when the ever-charming Russian President Vladimir Putin called the United States “a parasite on the global economy.”

Third, with the Fed shutting off the liquidity spigot by tapering quantitative easing — a policy that lifted risk assets like emerging markets across the planet — the bullish case for investing in emerging markets has just become a lot tougher.

As a result, there has been a shift in conventional wisdom about emerging markets.

Rather than a “one-size-fits-all” approach to investing in emerging markets, today’s investors are told they need to take a shotgun approach, winnowing the winners from the losers. This year, South Korea and Mexico are the favorites among “mainstream” emerging markets.

Certain frontier markets off the beaten path have also done well, largely thanks to the booming economies of the Gulf states of Kuwait and the United Arab Emirates.

Just look at how the Market Vectors Gulf States Index ETF (MES) (which I hold) has performed this year compared to the broader MSCI Emerging Markets Index.

Emerging Markets: A Classic Contrarian Bet

If all of this has you down on investing in emerging markets, you’re missing the point. Let me take you back to two years ago.

In January 2012, it was Europe that was “set to implode.” Permabear Nouriel Roubini confidently asserted that the euro zone would collapse in the coming year.

Investing in Greece or Ireland — like contrarian investor Wilbur Ross did at the time — is the last thing Roubini would have advised.

Fast forward to today, and what does Europe’s stock market scorecard for 2013 tell us?

Well, things unfolded pretty much as I wrote they would in January of this year.

Today, I have to search long and hard to find a market in Europe that is NOT up by double-digit percentages. Germany has quietly crept up to #2 best performer in the world in 2013, after 2013 champion Ireland. Indeed, a bet on Europe’s PIIGS — the worst of Europe’s worst crisis-ridden economies — would have served you well this year. Ireland has exited its bailout program and is up 39.74%. My Bank of Ireland (IRE) recommendation has soared an even-more-impressive 122.15%. And that’s after a gain of 30.62% in 2012. “Basket case” Greece is up 18.33%, beaten out by fellow PIIGS member Spain, which has soared 22.27%.

So what does this have to do with emerging markets?

Just as with Europe a year ago, it’s tough to cobble together a bullish case for emerging markets.

Yet it’s precisely because of all the negative sentiment surrounding emerging markets that I think they offer one of the very best investment opportunities today.

My criteria are disarmingly simple. Emerging markets are cheap. You hate them. And barring some Black Swan event, I believe they bottomed this past summer.

That’s also why a year or two from now, I expect to be writing about the “Remarkable Recovery of Emerging Markets.”

In case you missed it, I encourage you to read my e-letter column posted last week about how to deal with market predictions for 2014. I also invite you to comment in the space provided below.