Jun07

Jeffrey Gundlach: Bet on Emerging Markets

Posted by Mark Pettinga

Beauty may be in the eye of the beholder, but value is a more objective attribute, at least as it concerns investing.

Now, some investors are contemplating a bold emerging market trade after Jeffrey Gundlach, the head of DoubleLine Capital, recently presented a series of charts at the Sohn Investment Conference showing that emerging markets are underpriced and that the U.S. is overpriced. Gundlach advised buying the iShares MSCI Emerging Markets exchange-traded fund (ticker: EEM) and shorting the SPDR S&P 500 Trust (SPY).

The trade has resonated with many investors who are worried that the U.S. stock market’s extraordinary rally is unsustainable. Many investors have tried hedging U.S. stocks in anticipation of a decline, and they have lost money as shares keep rising to higher highs, shrugging off every bearish thesis and trade that has been thrown against them.

The U.S. market’s strong performance is why we like using options to implement Gundlach’s trade. Options, of course, cost less than associated securities, and puts and calls help to limit risk. Though the trade is simple—essentially buying a bullish call and bearish put spread—timing is the tricky part. There is no way to anticipate when U.S. stocks will falter and when emerging markets will surge. We are thus recommending investors consider a January expiration to give Gundlach’s thesis time to evolve.

When EEM was at $41.78, the January $43 call was at $1.62.

To lower the cost of shorting SPY, investors should consider a “spread” that involves buying a put and selling another with a lower strike price. When SPY was at $244.21, the SPY January $240 put was at $8.52 and the January $230 put was at $5.76. The spread’s net cost is $2.76, which means investors are risking that amount to make a maximum profit of $7.24.

Gundlach’s trading recommendation seems like a bold call to bet against the U.S., but it is basically a “pairs trade.” The strategy is used when one security is deemed undervalued and a related security is deemed overvalued. The goal is to profit from strength in one and weakness in another. Many investors use the strategy for same-sector stocks. They may buy Exxon Mobil (XOM), for example, and short Chevron (CVX), to profit from a potential widening of the spread between the two.

While it is something of a mantra on Wall Street to fret that U.S. stocks are headed for a tumble, stocks remain at historically high levels.

Gundlach’s trade, however, is animated by data that suggests U.S. stocks are priced at unsustainable levels, while emerging markets are at sharply more favorable levels.

The cyclically adjusted price/earnings ratio, or CAPE, shows U.S. stocks at 28.20, while the MSCI Emerging Market Index is at 14.05. The implication is that U.S. stocks are at extraordinary high levels, auguring poorly for the future, while emerging market stocks are more attractively priced.

A price-to-book ratio comparison reveals a similar disconnect. The Standard & Poor’s 500 index sits at 3.1 and the MSCI Emerging Markets Index is at 1.7.

Though a rising U.S. dollar is generally thought to be bad for emerging market stocks, a Gundlach chart mapping the relationship over 30 years show the impact is actually muted.

We could cite a dozen reasons in support of Gundlach’s thesis, but it basically comes down to this: We think emerging markets are well positioned, and we don’t really mind a cost-effective hedge on U.S. stocks that could return 100%. – By Steven M. Sears, Barron’s, June 5, 2017.