In China’s resurgent stock market, there’s a lesson for investors about the perils of market timing.
Even after the rally in Chinese stocks that began last month, the widely followed Hang Seng Index and Shanghai Shenzhen CSI 300 Index are no higher than they were nearly two decades ago. It’s not just China. The country represents nearly a third of the MSCI Emerging Markets Index, and it, too, is no higher than it was back in 2007.
Investor enthusiasm for emerging markets has waned since then. One indication is that from 2005 to 2009, exchange-traded funds that invest in developed countries took in five times as much money as ETFs that target developing ones, according to Bloomberg Intelligence. That makes sense because emerging markets represent a fraction of global stocks by market value. But that ratio jumped to 12 times in the subsequent five years through 2014 and to 19 times since 2020.
Emerging markets have tried to rally numerous times in the past two decades, always unsuccessfully. They won’t stay laggards forever. Collectively, the countries in the EM index account for about 40% of global economic output and are home to hundreds of the biggest and most-profitable companies in the world. Over the long term, their stocks should perform as well as those in developed countries, and they have historically, although not always at the same time. China’s recently announced stimulus measures could spark a long-awaited resurgence for emerging markets, and if so, investors waiting on the sidelines are likely to miss more of the upside than they might think.
That’s because a big chunk of the payoff in bull markets tends to come early on. The data on emerging markets only stretches back to the late 1980s, but the record for US stocks is longer — and instructive. I counted 12 bull markets for the S&P 500 Index since World War II, and on average, a third of the total return was achieved in the first year. Three notable exceptions were the long bull markets that began in 1949, 1987 and 2009. In those cases, investors could have sat out the first year without missing much.
The problem is that it’s impossible to know how long bull markets will last. Their average duration was just over five years during the past eight decades, but with a lot of variation around that average. Waiting around to see how things played out would have been costly. Excluding the first year of each of the past 12 bull markets, the S&P 500’s total return drops by 3.8 percentage points a year since 1946.
Investors routinely pay a penalty for mistiming markets. Morningstar’s annual Mind the Gap report measures the difference between fund returns and how much of those returns investors captured. Every year, the report shows that investors routinely fall short.
It also strongly suggests that the more volatile an investment, the greater the shortfall. The report doesn’t single out emerging markets, but the shortfall for investors in non-US stock funds was 0.7 percentage points a year during the 10 years through 2023. And given that stocks in emerging markets are among the most volatile, there’s a good chance their gap is even higher.
The solution is boring but effective: Decide how much of your stock portfolio you want to allocate to emerging markets and stick with it. When in doubt, a good rule of thumb is to track emerging markets’ share of global market value, which is currently about 10%. Maintaining that level will require adding to emerging markets when they underperform, which is the last thing anyone wants to do in that moment — and just the opposite of what investors have been doing in recent years, as the ETF flow data suggests.
And in that moment — ahem, this moment — it helps to remember that emerging markets are not always stragglers. For most of the 2000s, they were the place to be, with the EM index outpacing the S&P 500 by a staggering 21 percentage points a year from 2001 to 2007.
They were also more sought after than US stocks. In 2007, the EM index traded at a 25% premium to the S&P 500 as a multiple of 10-year trailing average earnings after inflation. Now it’s the reverse, with emerging markets trading at a 44% discount. It will eventually flip again — a preview of how far this nascent China and emerging markets rally could run.
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