Money Matters: Is the Emerging Markets Craze Over?
After six years of trouncing the global equity markets, the stocks of companies in emerging markets are off to a sluggish start in 2007. Could this finally be the year that the emerging markets stumble?
Most investors are betting no. A recent survey of money managers by the Russell Investment Group showed that most remain bullish on shares of companies based in the emerging economies of Asia, Latin America, and Eastern Europe.
It's easy to see why. Over the past five years, the average diversified emerging markets stock fund has gained about 25 percent annually. By comparison, U.S. equities, as measured by the Dow Jones industrial average, returned only around 5 percent a year during this same stretch. And last year, when the Standard & Poor's 500 index of U.S. stocks was up an impressive 15.8 percent, emerging markets equities generated nearly twice those gains.
Not surprisingly, mutual fund investors have been pouring record amounts of new money into these red-hot investments. Yet the history of investing shows that just when investors become enamored of an asset class and think that it can't lose money, the investment often does just that. Consider technology stocks in 2000 or real-estate investments over the past couple of years.
To be sure, despite six years of stunning gains, emerging markets stocks still don't look as frothy as technology stocks did in the late 1990s. Emerging markets stocks are trading at a price-to-earnings ratio of around 13, based on 2007 estimated earnings. Meanwhile, profits among emerging markets companies are forecast to grow around 14 percent.
By comparison, the S&P 500 is trading at a P/E of around 15, but its earnings are expected to climb only around 7 or 8 percent.
Still, valuations are only as good as the earnings that they're based on. And a recent survey by Merrill Lynch showed that money managers aren't terribly confident about the quality and consistency of profits in emerging markets. A majority, in fact, rate the quality of profits generated by companies in the emerging markets as the worst in the world.
Moreover, one of the driving forces that propelled emerging markets profits in recent yearsthe bull market in commoditiesappears to be slowing. As energy and commodity prices have stabilized in recent months, fewer and fewer investors are "overweighting" commodity investments in their portfolios, according to Merrill Lynch. And since many of the world's industrial commodities are mined or processed in the emerging markets, this could put a damper on the economies in those countries.
That has already begun. So far this year, emerging markets stocks based in Asia are up only 1.6 percent on average, according to Morgan Stanley Capital International. Meanwhile, emerging markets stocks based in Eastern Europe are down 3.1 percent. By comparison, foreign stocks in the developed markets of Western Europe and Japan are up 4.4 percent year to date, according to MSCI. And the S&P 500 is up around 3 percent.
So what should investors in emerging markets stocks do?
Don't be scared to make emerging markets a permanent part of your diversified portfolio. But limit your exposure to 5 percent of your total holdings. Alec Young, international equity strategist with Standard & Poor's, says the emerging markets have matured to the point where investors should feel comfortable "owning them for the long term." But he cautions against investing more than 5 percent of your total portfolio in this asset class. He argues that an additional 15 percent of your money should be held in the stocks of companies based in the more developed overseas economies.