Unlike the S&P 500 (NYSE: SPY) and stock markets in many parts of the world, the emerging markets sector (NYSE: EEM) has failed to meaningfully participate in the global breakout to new highs. Its underperformance began in early 2018 when it peaked following a two-year, 100% rally. Since then, emerging markets dropped around 25% in 2018. This year, it's mostly been range-bound within a 10% range until past weeks when it's poked above this range. It's also about 20% below its 2018 peak.
Emerging Markets' Significance
In terms of the broader market, emerging markets are considered a leading indicator of risk appetites. Typically, periods of stock market strength correlate with outperformance in emerging markets as investors grow more risk-tolerant and seek out higher returns. Additionally, emerging markets are more leveraged to global growth as well.
Therefore the lack of leadership from emerging markets this year and continued underperformance despite strength in developed market stocks, is certainly concerning. This divergence can resolve in three ways. One possibility is that emerging markets catch a bid and start outperforming. This is currently happening with small-caps and cyclical stocks.
Another option is that the underperformance in emerging markets is an indicator that the rally in equities is vulnerable to a retracement. If stocks do start selling-off, emerging markets will lead to the downside. The third option is the most unexciting - the status quo lasts for another long period, frustrating both bulls and bears.
Emerging Markets' Composition
Emerging markets are primarily composed of four countries - China, India, Russia, and Brazil. These countries are grouped due to their relatively large size and rapid growth rates. However, each has its own set of strengths and weaknesses. A decade ago, these countries were primarily export-dependent, so they tended to trade in-step with each other in terms of growth and stock prices.
However as their economies have matured and become more consumer-centric, their fortunes are diverging as well. For example, India's stock market (NYSE: PIN) has been remarkably strong, making new highs regularly since early-2017. In contrast, the Chinese stock market (NYSE: FXI) is 40% below its highs made in 2015 and has failed to participate in the global stock market rally over the past three months.
Both Russian and Brazilian stocks' performance is closer to India than China. The bulk of emerging markets' weakness is due to China. Absent China, it's likely that the sector would be at new highs like other global indices. China's struggles are due to its monstrous debt overhang, deleveraging, and trade tussle with the US.
Ignore EEM Underperformance
Due to this, bears should not overweight this lack of confirmation. Instead, they should look at other cyclical stocks that are significantly outperforming for the first time in years.