Emerging Markets May Have Topped Out After Oversold Rally

Emerging markets may have topped out following oversold bounces off deep December 2018 lows. However, new lows aren't likely in the coming months because broad-based sector instruments have drawn double bottom reversals that are likely to presage many months of sideways action. As a result, investors looking for long-side exposure should limit efforts to sector leadership that, according to a recent Forbes survey, includes Poland and Hungary as top plays.

Emerging markets can be traded as a group through a variety of exchange-traded funds (ETFs). The three most popular instruments by total assets are Vanguard FTSE Emerging Markets ETF (VWO) at $61.1 million, the iShares Core MSCI Emerging Markets ETF (IEMG) at $57.4 million and the iShares MSCI Emerging Markets ETF (EEM) at $33.7 million. The price charts are nearly identical, while EEM has the longest price history, coming public in April 2003.

EEM Long-Term Chart (2003 – 2019)

The fund entered an immediate uptrend in 2003, carving a broad Elliott five-wave rally into the October 2007 all-time high at $55.83. It carved a small double top pattern into August 2008 and broke down, accelerating lower into November's four-year low in the upper teens. That marked the lowest low in the past 10 years, ahead of a healthy recovery wave that stalled near $50 in 2011, at the same time that commodities and Chinese growth were topping out. 

A pullback into October 2011 found support at $33.42, completing a trading range that held intact into a 2015 breakdown that reached a seven-year low in the mid-$20s in the first quarter of 2016. Bulls took firm control at that level, posting healthy gains that continued into a test of the 2011 high in February 2015. Aggressive sellers emerged when the fund broke resistance, triggering a failed breakout, ahead of a persistent decline that reached a 19-month low in October. It tested that level successfully in December and turned higher through January 2019.

The .786 Fibonacci retracement of last decade's bear market has ended two rally attempts, while price action has settled back in the trading range in place between 2011 and 2015. The 50-month exponential moving average (EMA) has eased into a horizontal orientation at the same level it held during that period, signifying a neutral technical outlook. Meanwhile, the monthly stochastics oscillator flipped into a buy cycle in July 2018, presaging a more balanced tape.

EEM Short-Term Chart (2017 – 2019)

The decline into October 2018 ended near the .618 Fibonacci retracement of the 2017 into 2018 uptrend, while the December test completed a double bottom reversal, predicting that support in the mid-$30s will hold for now. The bounce through January 2019 reversed at the .382 retracement of the 10-month decline, which has narrowly aligned with the .382 rally retracement, 200-day EMA and the top of the double bottom pattern.

The recent reversal at quadruple resistance may signal the start of a testing or base-building process that could last a few months and generate little or no upside. It's even possible that the short-term downturn will accelerate, dropping the fund into a dreaded triple bottom test. At a minimum, this complex price structure warns newly minted shareholders to tighten stops and consider taking profits.

The on-balance volume (OBV) accumulation-distribution indicator topped out with price in January 2018 and held up until a June breakdown that signaled aggressive distribution. It posted a lower low in December when price posted a higher low, generating a bearish divergence until the indicator mounted September and November highs. However, it has now dropped back under those levels (red line) in another red flag for an intermediate top.

The Bottom Line

The oversold bounce in emerging markets may have come to an end, setting the stage for sideways action that could persist for many months.

Disclosure: The author held no positions in the aforementioned securities or their derivatives at the time of publication.