After starting the year very poorly, emerging market stocks have rallied strongly, outpacing the S&P 500, explains Marvin Appel, editor of Systems & Forecasts.
Over the long term, emerging market stocks remain in a long-term trend of lagging the S&P 500 Index (SPX). There is some evidence that this is due to reverse in the months ahead.
Profit margins in publicly traded emerging market companies have historically been higher than profit margins in developed-country companies, presumably reflecting higher business risk in emerging markets.
For example, the current median profit margin for the MSCI Emerging Markets Index is 9.9%, compared to 8.2% for the MSCI World Index, which represents only developed countries.
Currently, the spread in profit margins is 1.7% (that is, 9.9%-8.2%). This spread of 1.7% is actually quite low by historical standards. The range of spreads between emerging market and developed country profit margins has ranged from 1% to 4.6% over the past 20 years.
According to Ned Davis Research, the spread between the median profit margin of the MSCI Emerging Markets Index and that of the MSCI World Index can be useful in detecting long-term trends in relative strength between these two indexes.
When the spread has widened (ie: increased relative profits in emerging market companies), the MSCI Emerging Market Index has outperformed by 7.3% per year. Conversely, when the spread has narrowed, emerging markets have lagged developed country stocks by 4.5% per year.
There has been one major exception to the correlation between emerging market stocks outperforming and profit spread widening. From 2004-2007, emerging market stocks outperformed, even though their profit margin advantage was shrinking.
Emerging markets have been losing ground almost continuously since the start of 2010. The relative strength of the iShares MSCI Emerging Market Index ETF (EEM) compared to the S&P 500 index peaked in October 2010, about the same time as when emerging markets profit margins were most favorable.
As the spread narrowed, EEM lost relative strength. In fact, since December 31, 2010, EEM has lost 4.7% in total return while the S&P 500 has returned 62%.
Profit margin spreads have not yet reversed. However, spreads are at the low end of their historical range, suggesting the possibility that emerging market profitability has more room to improve than to worsen (relative to developed country stocks).
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