I recently noticed an interesting disconnect in the world's stock markets, one that could mean profits in 2014 for those investors who take advantage. This forecast is based on one of the first short-term investing rules I learned in my initial training class with a proprietary trading firm.
The rule is that of correlation. Many stocks and markets appear to be correlated with one another. Simply stated, this means that if one stock out of a correlated pair makes a move, the other generally follows. If the other doesn't follow, this spells opportunity for the trader. Buying or selling the stock that disconnects from its historical correlated pattern with its match provides strong odds of profits.
Why is this? Well, based on past behavior, the stock that disconnects from the historical correlation generally will migrate back toward the correlation, producing profits for the investor who acts upon this disconnect.
That said, I am not implying that this is a sure thing. After all, there are no sure things in the stock market. Sometimes, previously correlated stocks become uncorrelated and never fall back in line with each other. But even so, this method can provide a statistical edge for the investor over time.
The same idea can be applied over the long term to entire markets and sectors. Take a look at this chart:
The chart shows exchange-traded funds (ETFs) that represent the U.S. stock market with the black line, the European stock market with the purple line, and emerging markets with the orange line. You can see the correlation between the three different markets since 2007.
In 2013, emerging markets started becoming uncorrelated with the U.S. and Europe. Next, correlation comes back into view, until later in 2013 when the U.S. and European stock markets took off on the upside. Finally, the real disconnect occurs. You can see the emerging markets turning downward at the $70 level, while the U.S. stocks pushed to $85 and European shares hit $80.
What this means is that history tells us the emerging markets have a strong chance of falling back into correlation with the rest of the world's stock markets. To say it bluntly, I think the emerging-market sector will advance in 2014, catching up with U.S. and European stock markets.
But I never base an investment decision strictly upon technical factors, no matter how compelling. The fundamental price drivers need to agree with the technical picture before I consider any investment. In this case, the fundamentals agree with the bullish case for emerging markets in 2014. Here are two brief examples of what I discovered.
China is the world's leading emerging market. Although its economic growth has slowed, China is still expected to surpass the U.S. as the world's largest economy over the next decade. I am a long-time China stock market bull and recently wrote about China's pro-growth stance and how consumption will soon ramp up substantially. Stocks in this country are trading at unbelievably low levels. According to the Financial Times, Chinese stocks trade for an average of just 7.7 times earnings.
Another major emerging market is Turkey. Turkey has long been the gateway between China and Western Europe. Turkish stocks are trading for an average of just 9 times earnings, creating bargain-basement prices.
As China gains strength, Turkey and the other emerging markets should follow. I think there really is no place to go but higher in the emerging markets.
Investors can participate in the projected emerging-market rebound with one of the many ETFs specializing in the sector. The iShares MSCI Frontier 100 ETF (NYSE: FM) and First Trust EM Small Cap AlphaDEX (NYSE: FEMS) make sense right now.
However, my #1 choice for emerging markets is the Hartford Emerging Markets Research Mutual Fund (Nasdaq: HERAX). The fund is heavily weighted in the financial, technology, and consumer cyclical emerging market sectors. As I noted in my previous article on China, I strongly believe the Chinese rebound will be led by consumption. Nearly 17% of the fund's holdings are spread across Samsung Electronics, Taiwan Semiconductor, China Pacific Insurance Group, the iShares Core MSCI Emerging Market ETF (NYSE: IEMG) and Tencent Holdings (Nasdaq: TCEHY). HERAX allows the investor to own a variety of emerging-market stocks along with an ETF in one instrument.
Risks to Consider: Emerging markets are risky by definition. These markets do not generally have the safeguards of established economies. Always use stop-loss orders and diversify your portfolio, no matter how compelling an idea may appear.
Action to Take --> Buying HERAX on a breakout close above $9 with a 12-month target price of $14 and an initial stop-loss just below $8 makes solid investment sense.