Here's the Smart Trade As Emerging Markets Soar – Barron's

This post was originally published on this site

While emerging markets equities are touted as ways to participate in growth on younger, more vigorous economies, they are also plays on easy U.S. financial conditions. When U.S. interest rates are low and the dollar is softening, American investors flock to markets from China to Indonesia as well as Brazil. So far this year, this trade has worked like a charm.

The iShares MSCI Emerging Market Index exchange-traded fund (ticker: EEM EEM 0.7967654986522911% iShares MSCI Emerging Markets ETF U.S.: NYSE Arca 37.3956 0.2956 0.7967654986522911% /Date(1471965129595-0500)/ Volume (Delayed 15m) : 5820159 P/E Ratio N/A Market Cap N/A Dividend Yield 1.420849358974359% Rev. per Employee N/A More quote details and news » ) is up about 35% from its January low, while the Standard & Poor’s 500 Index is up about 7% this year. And for the first time since 2012, estimated inflows of $1 billion into emerging-market funds stand in contrast to $42 billion exiting from developed-markets, according to Morningstar.

This extraordinary data point, which Calamos Investments recently highlighted on Twitter and expounded upon in the Emerging Markets column in this week’s Barron’s, suggests emerging markets are on the cusp of receiving a big infusion of even more new money.

Also, BlackRock, the world’s largest asset manager, Monday upgraded emerging market equities to Overweight from Neutral. “Investors have been warming up to emerging markets since February, and their risk appetite appears to be broadening. Even offshore Chinese equities — a performance laggard this year — have started to catch up despite weaker economic data from China in July,” Blackrock’s global chief investment strategist, Richard Turnill, wrote in a client note.

In essence, emerging markets offer faster growth than developed markets, including America, Europe and Japan. But investors who are suddenly recognizing the EM trade should be careful investing at this particular juncture in one of the year’s great rallies.

Flow data suggest that many retail investors may be arriving late to the trade. This could make them easy targets for institutional investors who bought into emerging markets at January’s lows, or even before. Pros perpetually profit by selling to individual investors who often think that anything that has rallied strongly in the past will surge even higher in the future. This is the essence of the buy-high, sell-low cycle that traps so many individual investors.

Moreover, Friday may bring about critical information about U.S. rate policy, when Fed Chair Janet Yellen delivers a much-anticipated address to the monetary policy confab in Jackson Hole, Wyo. That could redefine or episodically roil the risk markets, notably the EM trade.

To avoid being the fools of time and terror, as the poet Lord Byron once observed, investors interested in the iShares MSCI Emerging Market ETF can consider using options to define and control the risk.

Buying a call, rather than buying the ETF, lets investors participate in any rallies without paying – or risking – top dollar. Options cost less than stocks. Should the emerging-market rally soon sputter, investors can use the cash they would have otherwise spent to buy the dip.

With EEM around $37, consider buying the January $38 call. If EEM is at $42, the call would be worth $4 at expiration. If EEM stops rallying, and is below the call strike price at expiration, the trade is a failure.

The expiration essentially expresses a view that U.S. rates will not increase this year and the U.S. dollar will remain tame. The January expiration covers four key rate events. In addition to Yellen’s speech Friday, the Federal Open Market Committee will hold policy meetings Sept. 20-21, Nov. 1-2 and Dec. 13-14. Most Fed watchers don’t expect a rate hike until December, if indeed the FOMC moves at all in 2016.

The iShares MSCI Emerging Market Index is trading near an annual high. Over the past 52 weeks, the ETF has ranged from $27.61 to $37.98. Top holdings include Samsung Electronics (005930.KR), Tencent Holdings (700.HK), Taiwan Semiconductor ( TSM ), Alibaba Group Holding ( BABA BABA 0.7684265551489806% Alibaba Group Holding Ltd. ADR U.S.: NYSE USD96.385 0.735 0.7684265551489806% /Date(1471965132122-0500)/ Volume (Delayed 15m) : 1860171 P/E Ratio 21.82892859569264 Market Cap 238673218440.79 Dividend Yield N/A Rev. per Employee 480267 More quote details and news » ), and China Mobile ( CHL CHL 0.3020187569543793% China Mobile Ltd. ADR U.S.: NYSE USD63.1 0.19 0.3020187569543793% /Date(1471965119700-0500)/ Volume (Delayed 15m) : 30259 P/E Ratio 14.989783706200228 Market Cap 258399444453.87 Dividend Yield 3.037063755734852% Rev. per Employee 246800 More quote details and news » ).

Option-trading patterns, which often offer insight into how securities will trade, are mixed. EEM’s two top positions are the September $34 and $25 puts. This suggests, at least superficially, that investors have bought these puts in anticipation the ETF slips lower by year’s end. Of the almost 9 million contracts that are outstanding, 5.31 million are bearish puts and 3.62 million contracts are bullish calls.

During the past 10 sessions, trading patterns have tracked open-interest data. Investors are buying calls that match, or just exceed, EEM’s market price. They are often choosing September expirations.

Such positioning data is not definitive, but it reinforces the thesis that it makes sense to use calls when professional investors appear increasingly cautious while retail investors are rushing into EM.

STEVEN SEARS is the author of The Indomitable Investor: Why a Few Succeed in the Stock Market When Everyone Else Fails.

Comments? E-mail us at steve.sears@barrons.com

Like Barron’s Asia on Facebook

Follow Barron’s Asia on Twitter