Emerging Markets: Don't Go With the Flow

(MoneyWatch)  When searching for a good place to invest, try an approach that works well in uncovering vast criminal conspiracies: Follow the money.

Studying the flow of capital into or out of markets won't help you root out skullduggery, but it could help you build up your nest egg. The key is heading in the opposite direction once you know which way the money is going.

Markets tend to rise as more capital is funneled into them. No surprise there; it's the buying that pushes up prices.

But when the inflow over a given period is very high relative to historical norms, it can foretell a decline. That may seem counterintuitive, but not when you consider some basic mathematical and psychological truths.

Lopsided investment reflects a high degree of optimism that sets investors up for disappointment; it's as if they're paying in advance for good news that may or may not arrive. And there's only so much money to go around, so as more of it comes in, there's less left to keep prices moving ahead.

The same holds in reverse. When substantial cash comes out of a market, it raises the odds of a rally because investors are pricing in disappointment and there is plenty of cash available to come back in one day.

If you follow the money now, according to Michael Hartnett, international investment strategist at Banc of America Securities-Merrill Lynch, it will lead you into American stocks and out of emerging markets.

Hartnett noted in research for the bank's clients that $4 billion more was put into global emerging market equity mutual funds and their exchange-traded cousins in the week through May 6 than was taken out. That is the highest total since December 2007 and the eighth highest on record.

Too Much Buying
And it was more than just a one-week wonder, he pointed out. The net inflow during the seven weeks through May 6 totaled $14.4 billion. That is too much, by his reckoning, and the strong flows amount to a sell signal for the emerging market universe.

"The best asset to buy is a despised, humiliated asset," Hartnett said.

You wouldn't know it to look at the last two months of trading, but that description could apply to American stocks. Nearly $10 billion has left the market in the seven weeks studied by Hartnett as investors have sold fiercely into the rally to cut losses incurred in the last year.

If a rise of nearly 40 percent in such a short period isn't enough to lure in money or assuage investors' anxiety, it's a sign that the move has a lot further to go as their fear gives way to calm and eventually to greed.

The recent popularity of emerging markets suggests that they have gone through that progression already. The MSCI Barra Emerging Markets Index has risen more than 50 percent since early March.

Hartnett acknowledged that his sell signal "continues to be wrong-footed" by the mammoth stimulus measures undertaken by governments in the developing world. It's common for emerging markets to lag mature ones early in a recovery as the public's risk appetite returns gradually; faith in the stimulus programs may have emboldened investors to jump back in sooner this time around.

Another appeal may be recognition that emerging economies and banking systems are healthier than they have been in past recessions and in many cases are healthier than economies in the West. Hartnett conceded that the comparative strength of emerging stock markets could stem from a perception that risks are lower there.

But he suggested an alternative explanation: The big gains "could be [the] mother of all head fakes within [the] mother of all bear market rallies."