“If you’re going to do something in emerging market equities, my recommendation is to short them. They may fall a further 40%.” – Jeff Gundlach, January 25, 2016

Jeff Gundlach hates Emerging Markets. So does almost every other pundit on financial TV. So do the rating agencies. Can you blame them?

Over the past five years (through February), while the S&P 500 has nearly doubled (+98.4%), the MSCI Emerging Markets Index is down 6.6%.

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The performance spread (over 100%) is the widest since the late 1990s. (Note: after which Emerging Markets would go on to outperform until late 2007.)

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Statistically, it would seem that there is no reason for U.S. investors to take on additional risk here in Emerging Market equities. We have data on EM going back to 1988. Since then, EM has underperformed the U.S. (9.3% annualized vs. 10% annualized) with significantly higher volatility (23% vs. 14%).

Lower returns and higher volatility. Why in the world would anyone want that?

Fair question. But investing is about the future, not the past. Simply picking the asset class with the highest recent return and lowest volatility has not generally been an effective strategy for long-term investment success.

The fact that EM has significantly underperformed the U.S. and is down over the past five years is actually a good thing for those considering diversifying into the asset class today for two reasons:

1) It means increased odds of higher prospective returns (long-term returns are highly correlated with beginning valuations which are more favorable today in EM than the U.S.), and

2) It means that EM can add diversification benefits through lower correlation (because EM does not move in lockstep with the U.S., it can be additive to a portfolio over time).

But what about the new Bond King?

Right, Mr. Gundlach is telling you to short Emerging Markets. Since he has been crowned the new bond king, no one asks if he himself is doing so (doubtful), and why a prediction of a 40% decline is coming after, not before, a five-year bear market that has taken Emerging Markets equities down 43%.

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But I digress.

I don’t know what will happen for the remainder of 2016; no one does.  As I’ve been writing on twitter over the past month, though, I do find it interesting that:

1) Emerging Market credit has been leading to the upside and held up extremely well at the February lows.

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2) Emerging Market Currencies are positive YTD and posting their strongest move to the upside in some time.

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3) The two cheapest and most hated Emerging Markets, Brazil and Russia (see Meb Faber’s recent piece on Global Valuations), are both positive YTD and outperforming U.S. equities.

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Perhaps Gundlach will be correct and Emerging Markets will decline another 40% from his call in January. However, if one is an asset allocator looking out over the next five to seven years, I’d say the odds are quite high that Emerging Markets will handily outperform the average bond fund. Bond math is quite simple: low yield = low forward returns, as I wrote about last year (“Bond Math and the Elephant in the Room”).  Will there be volatility in Emerging Markets between now and then? You can count on it, which is the price of admission when it comes to investing.

If long-term investors are thinking rationally, perhaps the greater fear today should not be in the Emerging Markets where they likely have little to no exposure, but in the bond portion of their portfolio. How do they expect to meet their retirement goals with a yield of around 2% in the average bond fund and Treasury Bills yielding less than 1%? How do they expect to close the gap between their lofty return expectations and the reality of low yields. There’s no easy answer to this question but I’d venture to guess that shorting Emerging Markets today (and getting that timing right on covering this short) is not likely to close that gap.