The Surprising Market That's Beating the Dow in 2014

The Dow Jones Industrials posted a modest 16-point gain in early afternoon trading Thursday, as investors tried to read whether the latest economic data points to future weakness in the economic recovery or merely represents short-term noise in an overall uptrend. But even as the Dow has managed to post new all-time highs in 2014, emerging markets have been extremely strong performers, with the Vanguard Emerging Markets and the iShares Emerging Markets  exchange-traded funds both crushing the blue-chip index this year by picking up between 7% and 8%. Let's look at the rebound in emerging markets and what it means for Dow investors.

Brazil prepares for the 2016 Olympics. Source: Wikimedia Commons.

A change in trend
Emerging markets have struggled for years. Even as the Dow Jones Industrials have posted consistently solid returns since the financial crisis, emerging markets have been much more vulnerable to volatility in both directions.

^DJI Chart

Market data by YCharts.

In particular, you can see how the Dow and emerging markets delinked toward the end of 2011. Global economic problems, especially the sovereign debt crisis in Europe, made U.S. investors think twice about taking on the added risk of international stocks, and emerging-market stocks in particular started missing out on the overall economic recovery. Moreover, major emerging markets China and Brazil saw dramatic slowdowns in the pace of their domestic economic growth; that led to currency declines in Brazil and a lack of market confidence in Chinese companies that further exacerbated their declines.

But since the beginning of 2014, emerging markets have finally started to recover:

^DJI Chart

Market data by YCharts.

Why the change in sentiment? After such an impressive run, the Dow has many investors worried that the U.S. stock market is overvalued. By contrast, emerging-market stocks have been down and out for so long that by traditional valuation metrics, many look relatively cheap by comparison.

In addition, pro-growth policies are taking hold in several emerging-market nations. Many believe that the recent election of Prime Minister Narendra Modi in India will bring with it renewed growth initiatives that could help that nation's long-struggling stock market start keeping pace with other markets around the world. Indian stocks have soared in response to this optimism. Brazil has finally seen a halt in the slide of its currency against the U.S. dollar, and the commodities markets on which so much of the Brazilian economy relies appear to be hitting bottom. For China's part, moves to halt the appreciation of the yuan could bolster the nation's export industry, giving the economy some breathing room as the rise of a domestic middle class takes root. Even Russia, amid huge uncertainty, has bounced back from the recent Ukraine-linked drop, as many believe that economic sanctions will prove either unnecessary or impotent in having any downward effect on the country's economy.

Even with their solid run this year, emerging markets look poised for further gains if the underlying fundamental economic growth that we're seeing doesn't lose steam. Investors look for alternatives to an increasingly pricey Dow Jones Industrial Average should consider whether emerging-market stocks deserve a bigger part of their overall portfolio.

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