Investor Insights:

  • Some people say you should just buy anything and everything.
  • That’s not my plan, and it shouldn’t be yours either.
  • Instead, focus on one market that’s crazily undervalued right now.

Recession? What recession?

In recent weeks, many people who were predicting an economic downturn earlier this year have made strenuous efforts to forget that they did so.

fears of recession plotted on a graph

It’s all smooth sailing from here, they say.

Indeed, the last two weeks have seen a remarkable turnaround on several fronts, all of which suggest that the economy is in no immediate danger of a slowdown.

It’s quite a list:

  • The U.S. and China have agreed to a “phase 1” trade deal.
  • Congress has approved a new continental trade deal, the United States-Mexico-Canada Agreement, which replaces the North American Free Trade Agreement.
  • Boris Johnson’s Conservative Party won a resounding victory in Britain, confirming that the United Kingdom will be withdrawing from the European Union next year.
  • The Federal Reserve has made it clear that it sees no prospect of rate increases next year. In fact, the Fed has finally admitted that its fears of inflation from extremely low unemployment were wrong.

When you add all this together, it’s as if the economy has emerged from a long tunnel into the proverbial light.

Given all this, what’s an investor to do?

Here’s what I’m going to be doing, and why.

Buy It All? Bad Move

Some people see gains everywhere and anywhere.

Chris Rupkey, chief financial economist at MUFG Union Bank, says you should just buy anything and everything.

“Back up the truck and buy, buy, buy,” he says. “Take risk off the table as a concern to be hedged. There is no risk. … Bet on it. Buy it. Buy it all.”

Somebody should tell Rupkey that if you’re going to “buy it all,” you might as well just put all your money in the SPDR S&P 500 Trust ETF (NYSE: SPY). After all, that exchange-traded fund (ETF) already owns it all, at least as far as U.S equities are concerned.

That’s not my plan, and it shouldn’t be yours either.

I agree that we aren’t looking at a recession next year. But that doesn’t mean we’re guaranteed to see explosive growth in stock prices across the board.

It’s still important to find the investments that will generate above-market returns.

It’s a Big World out There

There will be winners next year in U.S. and European equities, as well as Chinese stocks. But that’s not where the big gains are going to be.

I predict that the biggest bounce from the removal of all the uncertainty we faced during 2019 will be felt in emerging markets. Here’s why:

  • In the United States, the resolution of trade conflicts with China and our immediate neighbors will encourage U.S. businesses to resume investment, which has dropped to historical lows in recent years. Corporate leaders will welcome the removal of uncertainty, but pent-up demand for investment will cut into profits, putting downward pressure on share prices.
  • In Europe, clarity on Brexit will help, but there’s a great deal more work to be done before the situation normalizes. Boris Johnson’s government will need to negotiate trade and other agreements not only with the European Union, but with the United States and other countries as well. So uncertainty will continue in Europe as everyone awaits the outcome of those negotiations.
  • In China, the government remains concerned about excessive debt in the economy, slowing growth and an unstable situation in Hong Kong. The removal of U.S. tariffs on Chinese exports will help those sectors. But the need to deleverage the economy, especially the real estate sector, will limit gross domestic product growth, and therefore market valuations of Chinese firms.

In addition to those headwinds, U.S. stocks remain in overvalued territory. That’s why many of the big investment banks are predicting overall gains of less than 10% for 2020.

So even though we’re unlikely to see a recession in the developed economies, we’re also not likely to see a dramatic takeoff.

By contrast, emerging markets are crazily undervalued relative to the U.S. market.

Whereas the S&P 500 Index (the blue area below) has gone from strength to strength over the last decade, emerging-market equities (the red line) have been trading sideways since 2018:

Emerging Markets Have Been Trading Sideways

Emerging Markets Have Been Trading Sideways

But look at that red line between 2016 and the beginning of 2018. The trend was unmistakable: up.

A broad basket of emerging-market equities rose by nearly 70% over those three years, compared to 45% for the S&P 500.

That all stopped in January 2018 … and it was because of the U.S.-China trade conflict.

You see, China may be the world’s factory these days, but it relies heavily on imported raw materials and components from emerging-market countries.

Fears that the Chinese economy would slow down because of the trade war thus led investors to sell emerging-market equities.

Mind the Gap

Those fears have been relieved for now. But the huge gap in valuations between emerging markets and developed markets tells me that the smart money is going to pour into emerging markets now in anticipation of big gains.

That’s why my recommendation is to buy that red line — the iShares MSCI Emerging Markets ETF (NYSE: EEM).

I predict 2020 is going to be a hot year for EEM … and for you, if you ignore silly advice to buy everything and focus on the hottest prospects.

Kind regards,

Ted Bauman

Editor, The Bauman Letter

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