Correlations have not only declined among U.S. stocks, but they have also declined between U.S. stocks and their emerging market counterparts. While U.S. stocks have held onto most of their 2013 gains, emerging markets have struggled, with a funk emanating from some of them.

India is particularly making financial headlines—unfortunately not in a good way. The rupee plunged by 3.7% yesterday to an all-time low of 68.85 against the U.S. dollar. Even though the currency did rebound slightly before the day was over, the rupee still experienced its largest single one-day drop since October 1995. The rupee is now down approximately 30% against the U.S. dollar since the start of May 2013.

India has several sovereign problems. News reports describe the country’s parliament as being dysfunctional, its economy is slowing, and there are concerns about the level of its government deficit. Economic reforms have not been instituted at the pace many foreign investors would like. A food subsidy bill passed by the lower house of the national assembly earlier in the week was criticized for adding to the nation’s budget deficit.

Not surprisingly, these concerns have created downward pressure on Indian stock prices. Since July 23, the S&P BSE Sensex has fallen by 9.4%.

It’s not just Indian stocks that are lagging their global peers. Since the start of May 2013, Indonesia’s Jakarta stock exchange is down by 19%, China’s Shanghai Composite is down by nearly 9% and Brazil’s Bovespa is down by approximately 6%.

One of the catalysts for the downward pressure on emerging market stocks is the rising interest rates in the U.S. Expectations for a tapering of bond purchases by the Federal Reserve that has led to speculation of a shift in investment capital away from emerging markets and into the U.S. At the very least, the thinking goes, if the Federal Reserve starts to tighten the spigot on monetary stimulus, there will be less cheap capital available to invest globally. Bank of Japan board member Yoshihisa Morimoto warned about this very possibility earlier today.

What’s lost in the daily headlines is that declining correlations between emerging market and U.S. stocks are normal during bull market periods. History shows that correlations between the two narrow during bear markets and widen during bull markets. Though the trend in correlations has narrowed since the 1970s, emerging markets still have different economies and political issues than the U.S. does. They also tend to be more volatile.

Closed-End Fund Discounts?

Given the slump in emerging market stocks, I did a cursory search on the Closed-End Fund Center website to see if there were funds trading at unusually large discounts to their net asset value (NAV). In particular, I looked at the emerging market funds trading with expense ratios below 2% that were trading at the largest percentage discounts to their NAV and had expense ratios below 2.0%.

When doing this type of analysis, it is important to consider the level of discount a fund has historically traded at. The Mexico Equity & Income Fund (MXE) may seem like a bargain with a discount of 12.45% to its NAV, until the five-year average discount of 12.229% is considered. There are funds trading at bigger than normal discounts, however.

The two largest relative discounts I saw were for the Templeton Russia & East European Fund (TRF) and the Morgan Stanley India Investment Fund (IFF). The first fund currently trades at a 10.75% discount to NAV, versus a five-year average premium of 1.113%. The second currently trades at a 11.07% discount to NAV. The five-year average discount is 6.597%. Keep in mind, however, that if the underlying assets fall further in price, the current discount may not be large enough to protect you from incurring a loss.

More on AAII.com

• International Diversification: Why It Still Makes Sense – Bernard Horn discussed rise and fall of correlations between U.S. and emerging market stocks in this 2010 AAII Journal article.
• Using Currencies to Diversify Your Portfolio – Investing in, as opposed to trading, international currencies can provide diversification benefits, as Axel Merk of Merk Investments explained.
• What Is Your Approach to Emerging Markets? – Tell us on the AAII.com Discussion Boards.
• Don’t forget to take the Sentiment Survey.

The Week Ahead

The U.S. financial markets will be closed on Monday, September 2, in observance of Labor Day.

Just three members of the S&P 500 will report earnings: H&R Block (HRB) on Tuesday and Dollar General (DG) and SAIC (SAI) on Wednesday.

The week’s first economic reports will be the August ISM manufacturing index, the August PMI manufacturing index and July construction spending. All three reports will be released on Tuesday. Wednesday will feature July international trade data and the periodic Federal Reserve Beige Book. The August ADP Employment Report, the August ISM services index and July factory orders will be released on Thursday. Friday will feature August jobs data, which will include the unemployment rate and the change in nonfarm payrolls.

Two Federal Reserve officials will make public appearances. San Francisco president John Williams will speak on Wednesday and Minneapolis president Narayana Kocherlakota will speak on Wednesday and Thursday.

AAII Sentiment Survey

Neutral sentiment rose back above its historical average, as pessimism fell in the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, rebounded by 4.6 percentage points to 33.5%. Even with the rise, optimism is below its historical average of 39.0% for the fourth time in five weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged, rebounded by 7.5 percentage points to 35.7%. This is the 19th time in 23 weeks that neutral sentiment is above its historical average of 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, pulled back by 12.1 percentage points to 30.7%. The drop ends a streak of six consecutive weeks with rising levels of pessimism. The historical average is 30.5%.

The sharp pullback in bearish sentiment is not surprising given the ongoing volatility we have seen in the survey results over the past several months. The drop in pessimism should not be confused with signaling a more bullish stance on the part of individual investors, however. Many remain cautious given current market valuations, slow economic growth, the possibility of the Federal Reserve tapering its bond purchases and a lack of progress on key issues by Congress and the president. The approximate 4% decline in stock prices since early August is also having some effect on sentiment.

This week’s special question asked AAII members if they allocate more to individual stocks or to index funds. More than a third (37%) said they allocate more to stocks. Greater control and the chance to beat the market were the primary reasons given as to why. Slightly less than a quarter of respondents (23%) said they allocate more to index funds. Less risk and more diversification were the reasons given as to why. Notably, 8% said they are allocating more to cash or intend to raise their cash allocations, even though we did not ask them about this.

Here is a sampling of the responses:

• “Individual stocks. I want to do better than the indexes.”
• “Individual stocks because the correlation is less than it is with index funds.”
• “Index funds are the easiest and safest way to get market coverage and diversification.”
• “Index funds. I’m trying to eliminate the risk of individual stock fluctuations.”
• “More to individual stocks that pay dividends. I am near retirement age.”