Emerging markets warning

What I mean is that the ratio of the money stock in OECD economies to developed countries’ share prices is now low. If we adjust for its long-term upward trend it is now close to the lowest it has been since early 2008. On the two previous occasions when it has been this low, emerging markets shares subsequently fell a lot; the other occasion was in 2000.

My chart shows that there is a reasonable correlation between this ratio and subsequent three-year changes in emerging markets. A high ratio of the money stock to share prices leads to emerging markets rising, and a low ratio to them falling. If post-1996 relations continue to hold, this points to a greater than 50:50 chance of emerging markets falling over the next three years.

Granted, the correlation is far from perfect. But then there shouldn’t be that much predictability in share prices. The price-money ratio alone has predicted almost one-third of the substantial variation in three-yearly returns on emerging markets since 1996. That’s better than nothing.

You might find it odd that financial conditions aren’t supportive of shares given that we’ve seen trillions of pounds of quantitative easing in western economies since 2009.

In truth, though, there’s no puzzle at all. For one thing, central banks’ printing of money has only made up for the fact that banks have created less money since the crisis (which is another way of saying they have lent less), with the result that aggregate monetary growth has been no faster in recent years than it was before 2008. And for another, share prices have risen even faster than the money stock. This means that western investors now have unusually large quantities of equities in their portfolios and relatively little cash.

Herein lies the reason why this ratio predicts emerging markets returns. When investors have lots of shares and little cash, it is a sign that they are confident enough to own lots of risky assets. This, however, means that good news is more likely to be in the price and bad news not. It also means that sentiment is more likely to fall than to rise: people in aggregate rarely stay very optimistic for very long. On both counts, shares are more likely to fall than rise.

This matters for emerging markets simply because these are more sensitive than others to changes in sentiment. Emerging markets companies, more so than their western counterparts, sometimes have obscure accounting practices, unusual corporate governance structures or are simply less familiar to investors. Because they are harder to value with conventional metrics, sentiment matters more for them than it does for better-known western shares.

It’s also for this reason that my chart shows three-yearly changes rather than shorter-term ones. Over short periods (which can last for many months) bullish investors can become even more bullish and so over-priced stocks can become more over-priced. It’s only over longer periods that sentiment mean-reverts and so the price-money ratio predicts returns.

Which raises another reason to steer clear of emerging markets. MSCI’s index of them in US dollar terms has fallen below its 10-month average. Historically, it has made good sense to sell when this happens: doing so would have saved us from big losses in 1998, 2000-01 and 2008-09. This is because sentiment-driven assets such as emerging markets tend to be more prone to momentum than others.

Now, this isn’t to say that the outlook is catastrophic. Sentiment isn’t as over-exuberant as it was earlier this year, and the price-money ratio says there is almost a 50:50 chance of them rising over the next three years. Nevertheless, we have two good lead indicators – the 10-month average and the price-money ratio – which are warning us of the possibility of a loss. And I know of no lead indicator of comparable power pointing on the other hand to good returns. For me personally, therefore, the risks to buying emerging markets now seem to be too great.