AAII Investor Update: Emerging Markets and Future Volatility

Thursday, June 14, 2012
Charles Rotblut, CFA
AAII Journal Editor

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 34.0%, up 6.6 points
  Neutral: 30.2%, up 3.4 points
  Bearish: 35.8%, down 10.0 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »


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I was asked last week if volatility will increase in the future. Any forecast is subject to error, but I answered that we could see more volatility. My reason for expecting more volatility is the growth in emerging market economies.

Before I explain why, I want to define volatility. I am specifically referring to large market moves—bull markets, bear markets, strong market rallies and painful market corrections. Notice both the good and the bad in the previous sentence. Volatility is often viewed in a negative light, but a day that sees the Dow gain more than 2% is just as volatile as a day that sees the Dow fall by 2% or more. Volatility is the magnitude of change, not the direction. I can’t predict what will happen on a day-to-day basis, but I can see trends that could create more risk and more potential reward.

As far as emerging markets are concerned, this is where economic growth is stronger, as many of you know. China, Brazil and India all have burgeoning economies. Russia is also benefiting from its vast commodity resources, particularly in supplying oil and gas. As a whole, emerging market economies account for about 36% of global GDP, according to David Hale of David Hale Global Economics, Inc.

What doesn’t receive as much attention is the burgeoning trade that is occurring between countries. This is particularly the case with China, which ranks among the largest trading partners for many countries, including Brazil and India. (The World Factbook, published by the CIA, has a list of each country’s major trading partners.) As countries trade more with each other, weakness in one country has the potential to impact the economy of another.

Though overall growth has been very good, it is important to realize that emerging market economies are, well, emerging. These are still young economies, and we do not know how well their leaders will handle inflationary pressures, credit issues and economic slumps within their own borders. Given that the leaders of developed countries still haven’t figured out the secret to long-lasting economic bliss, there is little reason to believe that emerging market leaders have a magical elixir.

Therein lies the potential for future volatility. If China catches a cold, the rest of the world could get the sniffles, if not worse. The country did weather the last crisis well (in part due to a stimulus program), but that was a global issue, not a financial (or an economic) problem centered within China’s borders. Weakness in other large emerging markets, such as Brazil and India, would also have the potential to rattle markets in the U.S.

On the other hand, in terms of global scale, emerging markets are growing. Though this will likely cause correlations between international markets and the U.S. market to move closer together than they have been on a historical long-term basis, there will still be diversification benefits that can be realized by investing in these foreign countries. The key is to have a long-term outlook, patience and willingness to withstand any volatility they may bring.

More on AAII.com

The Week Ahead

Approximately 10 members of the S&P 500 will report earnings next week. Included in this group are Adobe (ADBE) and FedEx (FDX) on Tuesday; Bed, Bath & Beyond (BBBY) on Wednesday; and Oracle (ORCL) on Thursday.

The week’s first economic report will be the National Association of Home Builders’ June housing market index, which will be published on Monday. Tuesday will feature May housing starts and building permits. May existing home sales and the June Philadelphia Federal Reserve manufacturing survey will be published on Thursday.

The Federal Open Market Committee will hold a two-day meeting starting on Tuesday. The meeting statement will be published on Wednesday at 12:30 p.m. ET. Chairman Ben Bernanke will hold a press conference later that afternoon at 2:15 p.m. ET.

The Treasury Department will auction $7 billion of 30-year Treasury Inflation-Protected Securities (TIPS) on Thursday.

AAII Sentiment Survey

Bullish sentiment rose to a six-week high, while bearish sentiment plunged in the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, jumped 6.6 percentage points to 34.0%. This is the highest level of optimism since May 3, 2012. Nonetheless, bullish sentiment is below its historical average of 39% for the 11th consecutive week.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 3.4 percentage points to 30.2%. Even with the improvement, neutral sentiment stayed below its historical average for the fifth consecutive week.

Bearish sentiment, expectations that stock prices will fall over the next six months, plunged 10.0 percentage points to 35.8%. This is the largest one-week drop in pessimism since January 5, 2012. Even with the plunge, bearish sentiment is above its historical average of 30% for the ninth time out of the past 10 weeks.

The recent rebound in stock prices helped to calm the nerves of some investors, but many remain fearful that further declines could come. Worries that the European sovereign debt crisis and a slower pace of U.S. economic growth will lead to a repeat of last summer’s correction are keeping pessimism at above-average levels. As we noted last week, nearly half of surveyed AAII members said they were taking on less risk than they were six months ago.

This week’s special question asked AAII members if they thought stock valuations are now attractive from a long-term standpoint. Approximately two-thirds of respondents said yes, they are. The primary reasons given were strong balance sheets and low price-earnings ratios. Close to a third of respondents said no, valuations are not attractive. These members cited sovereign debt problems and expectations that stock prices will fall further as the reasons for their pessimism.

Here is a sampling of the responses:

  • “Valuations are attractive. Productivity and profits continue to rise.”
  • “Yes, due to low multiples and strong corporate balance sheets.”
  • “Yes. The large corporations have good balance sheets, and price-earnings ratios are attractive.”
  • “No, profit margins are near all-time highs. I believe they will revert closer to the mean in the years ahead.”
  • “No, the market will fall further before the election and Europe are settled.”

» Take the sentiment survey