Despite the GSE package announced by the U.S. authorities over the weekend, emerging market share prices have remained under siege. There are two undercurrents driving the accelerating sell-off: massive liquidation by long-term investors; and concerns about the next casualty in the U.S. financial system (like the Lehman Brothers, whose stock price is collapsing amid speculation the firm could be heading into bankruptcy).
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CAPITULATION PHASE
BCA Research
09 September 2008
Despite the GSE package announced by the U.S. authorities over the weekend, emerging market share prices have remained under siege. There are two undercurrents driving the accelerating sell-off: massive liquidation by long-term investors; and concerns about the next casualty in the U.S. financial system (like the Lehman Brothers, whose stock price is collapsing amid speculation the firm could be heading into bankruptcy).
As we argued in last week’s bulletin emerging market share prices have entered a capitulation phase (Chart 1). Capitulation and liquidation phases more often than not produce undershoots and ultimately create good buying opportunities. However, the duration and magnitude of any liquidation phase is difficult to forecast.
Taking into account the current backdrop of decelerating global growth, downward pressure on commodity prices and a global flight to safety, it is not surprising that emerging markets have underperformed of late. Our recommended strategy for equity investors is as follows:
• Remain on the sidelines and wait for a buying opportunity, which will likely emerge over the next few weeks. We recommended selling emerging market stocks on June 13 and have been waiting for a good entry paint since.
While it is hard to know how far prices will fall in the near run, capitulation phases are usually sharp and abrupt rather than drawn out affairs.
• For long-term investors who hold emerging markets as part of their global asset allocation portfolios, we do not recommend selling at this point. The latest round of selloff has been indiscriminate, suggesting it is more likely liquidation - rather t.han fundamental-driven selling.
• Several reasons lead us to expect a rally sooner than later:
The first is improved valuations. We are currently working on a Special Report on emerging equity market valuations that will be published in the next few days.
Second, emerging markets are as oversold as they were in 2001 (please refer to third panel of Chart 1). The technical profile is consistent with our bias that the cyclical bear market is late.
Finally, sentiment has become quite bearish and investors’ holdings of emerging market equities have been scaled back substantially in the past several months. From a contrarian perspective, this is supportive for the stock market in the months ahead.
Bottom Line: The selloff has entered a capitulation phase, which, albeit inherently dangerous and unpredictable, will likely produce a buying opportunity sooner rather than later.
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