Emerging Markets Fever

I am back after a long hiatus from blogging as family responsibilities kept getting in the way ;-) First, Happy New Year to all of you! Phew, what a year 2007 was for the markets and I am happy to put it behind me. No, it was not particularly bad (even the anemic U.S. markets ended positive for the year) but the roller-coaster ride put the "V" in Volatility back! The 4-year run in the raging bull market in international equities is still going strong. The Vanguard Emerging Markets Index fund (VEIEX) delivered a blistering 37.5% for the year. Even the developed country markets outside U.S. (notably, excluding Japan) delivered double digit returns in 2007. Meanwhile, the U.S. total stock market (VTSMX) delivered a paltry but positive 5.5% for the year, about the same as what a good money market fund would have yielded, without of course, any of the market risks.

What does this mean for 2008? Continue to invest in the winners and dump the losers? The emerging market story has never been stronger. Most of the emerging market countries are in the best shape ever. They have cleaned up their financial act, have a lot of currency reserves, stimulated domestic growth and are experiencing real improvements in the quality of life of their citizenry. Many leading emerging market companies are making bold forays into developed markets with mega-sized acquisitions of marquee names in business. Yet, after 5 years of impressive gains, most emerging market stocks are now trading at valuations far higher than many established developed market stocks. The "BRIC" countries (Brazil, Russia, India, China) are the hottest segment within the emerging markets and their stocks have had unbelievable runs in 2007. Many of these markets have transparency issues, notably poor disclosure requirements. Historically, investors have rewarded markets with greater transparency and accountability with higher P/E ratios because the earnings are more reliable and have fewer unknowns. The P/E ratios of stocks from India and China are now hovering 40-100% higher than those of U.S. stock market, considered the most transparent in the world. Strange, indeed!

William Bernstein in his 2002 classic The Four Pillars of Investing makes an interesting case backed by decades of market data that the best long term returns from equity markets are often not delivered by the hottest growth economies but by those weaker growth economies that do slightly better than what is expected of them. In other words, if China's GDP is expected to grow at 11% annually over the next five years and it actually delivered a 11% growth, as impressive as this is, the returns from its equities will not be nearly as high as say equity returns from a developed market expected to grow at say, 2% annually for the next five years, and it actually delivers a 3% annual growth. In other words, the best returns are captured where there are unexpected positive surprises. It is not the absolute growth numbers per se but the upside surprise that is rewarded in the markets.

With euphoria running as strong as it is in China and India, if growth hiccups even a little bit, say they achieve "only" 10% actual GDP growth, when the expectation has been 11%, the flight of capital from its equity markets will be so dramatic that it may take years for the stock markets in these countries to recover. With increasing foreign ownership in these emerging markets, it is easier than ever for capital to take flight.

Does this mean we should take the profits made so far from emerging markets and run? No. There is no substitute for a well-designed asset allocation plan that has a specified range of allocation for all types of diversified assets according to one's risk tolerance. If your allocation calls for a 10% holding in emerging market stocks and the past couple of years of stellar growth has increased it to 12%, consider if you are okay with this increase or re-balance with other asset classes to reach the 10% level again. Better yet, if you are contributing periodically to your investments, consider investing in other asset classes and temporarily stop allocations to emerging market stocks till they balance to your level of risk tolerance. The latter may be the slower method but it has no tax consequences if your assets are in a taxable account.

Nassim Taleb's theory of "black swans" says that all extraordinary movements in the market are as a result of random, unpredictable events that no amount of current market knowledge can predict. While I don't completely agree with the black swan theory (as it implies no individual can use any specialized knowledge to profitably trade in the markets or nobody has skills to identify and exploit emerging opportunities - Mr. Buffet and others would certainly disagree), there is certainly some element of truth in it especially when most market participants agree on one thing - chances are no big returns can be made in it for the long term. When everybody bets on a horse to win the race, there is nowhere to go but down for that horse. Sure it can win the race, but then everybody "knew it already". However, if it came even second, many will lose money as the odds are for it to win. On the other hand, if a horse nobody expects to win comes in even third in the race, those "idiots" who bet on it will walk away with huge winnings.

Since everybody in the investment world and popular media is crowing about China and India, I find it hard to imagine that this rampant optimism has not been priced already into these markets. There is a reason why underdogs win more often than champions. Because nobody expects them to!