Profits and growth depend on good management. Yet investors have the habit of lumping countries into categories based on vague criteria and assuming correlation across the class, a sure recipe for disaster in any language
Recently I read several articles on a popular US financial website owned by the Wall Street Journal which were on emerging markets in general and in particular the markets of Poland and Turkey. I found all of these articles rather troubling. They made two of the worst mistakes that investors and analysts make when considering investing in emerging markets.
The first mistake involves using the tools that investors have created for developed markets on emerging markets without considering that emerging markets might be very different. This is especially egregious when the tools really don’t work for developed markets in the first place.
One of these tools is the Dow Theory also known as technical analysis or chart reading. The Dow Theory was constructed from the writings of Charles Dow, the founder of Dow Jones. The theory became credible because it purportedly predicted the crash of 1929. Since then its results have been mixed. Since 1920, there have been 43 sell signals predicting a fall in the market of more than 20%. Of these, less than half, 17, actually resulted in such falls. Perhaps the real value of the Dow Theory is not that it actually predicts anything, but hoards of investors think it does.
However, those hoards may live over the hill and far away, so their opinions may only affect a local market. For example Chinese investors correctly react more to pronouncements of the government than to any real economic or corporate news for the simple reason that the government dominates the economy. A similar situation is developing in the US and Europe.
Markets are now less of a measure of corporate or economic health. Instead they are more attuned to pronouncements from the US Federal Reserve or the European Central bank as their unorthodox stimulus methods dominate economies. Yet the discrepancy between countries does not prevent prognosticators from making predictions using charts indicating obscure patterns all of which are basically meaningless.
Other tools have a better pedigree and are perhaps more accurate, but that does not necessarily mean that they can be translated. Analysts are quite fond of taking take historical trends and projecting them into the future. For example the combined amount of the BRIC (acronym for Brazil, Russia, India and China) contribution to global GDP is 20%, while the capital invested in their stock market is equal only to 16% of total equities, a spread of 4%. This observation is supposed to be helpful because the last time this happened, in 2005, the BRIC index rose 53%.The assumption is that the present valuation of the emerging markets is far too low and that eventually there will be some reversion to a more normal situation where market valuation equals GDP contribution. This is absurd. Stock market valuation reflects risk. Anyone remotely knowledgeable about emerging market understands that they are far more volatile and risky than markets with better information and better rules.
Another large mistake that investors and analysts make with emerging markets is to assume that basic facts about demographics, infrastructure and debt will automatically convert into sustained economic growth. Then they automatically assume that growth will translate into profits for foreign investors.
For example the articles about Poland and Turkey pointed to their youthful populations, low debt levels and expanding middle class as evidence that the countries were good places to invest. It suggested that any improvement in basic infrastructure would have a large impact on their economies.
Certainly these things are helpful for economic growth, but a youthful population and new middle class don’t always result in increased productivity or demand. For these things to translate into sustainable economic growth you need to educate the population and attract foreign investment. Many of the Arab countries have an educated youthful population that has been stymied by crony capitalism.
Besides, economic growth is subject to business cycles. Before the crash US consumers piled up debt worth 133% of GDP (gross domestic product). Now Chinese private sector debt is 127% of GDP. In Turkey and Poland private sector credit has risen by 20% in the last year.
Foreign capital and good exports can be a double-edged sword. In Turkey 78% of all financing flows are short-term. So the country is exposed to fickle foreign investors. Poland has increased its export sector by 40%, but its largest trading partner is Germany and the rest of the EU. Germany in turn is dependent upon exports to its southern neighbours and especially to China. Turkey is in the same position as Poland in that it is dependent upon exports to the EU.
It is ingrained in every analyst that all companies are different. Profits and growth depend on good management. Yet investors have developed the habit of lumping countries into categories based on vague criteria and assuming correlation across the class, a sure recipe for disaster in any language.
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages. Mr Gamble can be contacted at [email protected]
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