EEM - VWO: A Bullish Breakout Is In The Offing

Summary

• After a 16% rally since the bottom on October 25, the Vanguard FTSE Emerging Markets ETF (VWO) appears poised for further upside, with the China rally leading the way.
• While valuations have increased over recent months, the VWO remains undervalued from a historical perspective. Despite an expected collapse in earnings, the forward P/E ratio remains at 12.0x.
• The forward dividend yield of 3.6% on the FTSE Emerging Markets index is attractive even relative to U.S. Treasuries despite the recent yield spike.

My previous bullish article on the Vanguard FTSE Emerging Markets ETF ( VWO ) on October 25 came on the day of the market bottom and despite already seeing 16% returns since then the ETF appears to be just about to take off. Fundamentally, the index remains undervalued from a historical perspective and offers an increasingly attractive dividend yield of 3.6% on a forward basis.

The VWO ETF

The VWO tracks the performance of the FTSE Emerging Markets index and offers exposure to large-cap EM stocks with a very low expense ratio of 0.1%, which compares favorably to the 0.7% charge for the iShares MSCI Emerging Markets ETF ( EEM ). China has a higher weighting in the VWO, comprising 33% of the index versus 27% in the EEM. This largely reflects the absence of Korean stocks in the index, which contrasts with the EEM's 12% weighting. The absence of Korean tech giant Samsung also means a slightly lower weighting towards Technology.

A Classic Reversal Pattern

The recovery in the VWO looks like a classic reversal pattern. At the lows in October, I noted that rock bottom sentiment made a reversal likely and the focus is clearly now on the upside. A break above USD40.9 would mark a new cycle high, triggering a break of the 200-day moving average and a potential reversal pattern. Bulls would then set their sights on a run at the measured move target at USD47, which remains 16% above current levels.

A bullish breakout is made all the more likely by the price action in Chinese stocks. Down trendline resistance has been emphatically taken out on the Hang Seng China Enterprise Index and a run at the HKD8,000 looks likely.

China's recovery over the past few months has been the major driver of the recovery in the VWO. Chinese stocks have been the best performing of any major index since their lows in October, with the HSCEI rising by around 40% and the Technology sector rising by 60%.

Valuations Remain Cheap

While the rally in stock prices has raised valuations over recent months, the VWO remains undervalued from a historical perspective. The trailing PE ratio is just 10.1x and while earnings are expected to fall sharply over the next 12 months, the forward PE ratio is still only 12.0x, below the 10-year average of 12.7x. While earnings are expected to decline over the coming months, dividends are expected to rise, with the forward dividend yield currently at 3.6%, above the trailing figure of 3.3%.

While valuations remain on the low side, we have also seen a rise in real bond yields over the past year, which means the opportunity cost of holding stocks has risen. As the chart below shows, the dividend yield on the FTSE Emerging Markets index is now actually below that of the 10-year U.S. Treasury, after being significantly above it for most of the past three years.

There is certainly a case to be made for locking in these attractive Treasury yields, as I have argued recently here . However, I also believe that investors should have exposure to emerging market stocks, particularly if their portfolio is not positioned to benefit from rising inflation. The reason being that inflation is almost certain to be positive over the long term and nominal earnings and dividends on emerging market stocks are highly likely to rise as a result, which is not something that can be said for bond yields. To get a fair comparison between real return prospects on the VWO relative to USTs we should compare the VWO to U.S. inflation-linked bonds. When expected inflation is taken into account, the yield advantage of the VWO over USTs becomes clear.

Summary

The recovery in the VWO looks to be gaining steam as Chinese stocks lead a broad-based recovery in emerging market assets. Despite the strong rally already seen and widespread expectations for a decline in earnings, valuations are still below their long-term average and the forward dividend yield of 3.6% is attractive.

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