3 Reasons Why Emerging Market Investors Are Getting Dumped

By Louis Basenese on August 10, 2009

To say emerging markets are hot right now is an understatement.The benchmark MSCI Emerging Markets index is up 52% this year, rendering the S&P 500’s (^GSPC: 1010.48 +13.40 +1.34%) 11% uptick completely insignificant.Thanks to the strong performance, investors’ love affair with emerging markets keeps getting steamier. Case in point - investors poured $10.6 billion into emerging markets mutual funds so far this year, a whopping 34 times the total invested in U.S. funds.Yet, while most pundits shout from the rooftops that emerging markets are the place to invest right now, let me offer a dissenting opinion.

Three Reasons Emerging Market Investors Are Getting Dumped
Emerging markets investors - and their hard-earned capital - are about to get dumped on their derrieres. Here are three reasons why…
* Growth Doesn’t Pay
The justification for investing in emerging market stocks has always been the same - growth in emerging markets will far outstrip growth in the developed world and therefore, the profits will be greater.After all, doesn’t it make sense that a company doing business in a country with GDP expanding at a 7% annual clip will earn way more than a company doing business in a country with GDP contracting?
Seems logical and if that’s the case, emerging markets are definitely the place to be right now. Barclays estimates developing Asian economies will grow by 5.2% this year, compared to a 2.3% contraction for the United States.Here’s the rub: the classic justification is flawed. High economic growth does lead to higher profits for individual companies. But it doesn’t translate into higher stock returns for investors.

Based on decades of data from 53 countries, London Business School professor Elroy Dimson recently proved countries with the highest growth produce the lowest returns (6% per year), while countries with slowest growth produced the highest returns (12% per year).
How can this be? It’s simple, really. Attracted to higher growth, investors end up paying higher prices for emerging markets stocks, which cuts into returns.

Emerging Market Investors Violating Primary Rule of Investing
In other words, when it comes to emerging markets, investors lose their senses and consistently violate the primary rule of investing to buy low and sell high. And that’s certainly happening now…
* Valuations Hardly in Bargain Territory
If success in emerging markets boils down to buying in at the right price, now is not the right time.The MSCI Emerging Markets Index trades at 17.8 times earnings, the highest level since the index peaked in late 2007. In comparison, the S&P 500 trades at 17.2 times earnings.

Moreover, the historical average for the MSCI index is roughly 14 times earnings, making current prices seem a bit stretched.
* No Safe Haven… Nasty Corrections Are the Norm
While emerging markets stocks can make you a fortune in a hurry, they can just as easily ruin you. Just consider:
* In the six weeks following Lehman’s collapse, emerging markets shed 47%, slightly more than the S&P 500 index, proving higher economic growth provides absolutely no buffer.
* After advancing more than 20% for five straight years through 2007, emerging markets cratered 53.3% in 2008. Remember, the S&P 500 “only” dropped 37.6% last year.
* In 2000, when the U.S. market slid 9.1%, emerging markets tanked 30.8%.

Emerging Markets Headed For Short-Term Profit Correction
Bottom line, I’m convinced emerging markets are headed for a short-term profit taking correction.
* Historical data proves these markets are susceptible to such sell offs.
* Valuations are getting stretched.
* And investors have never been more enamored with such stocks.
* Even the financial press can’t resist the euphoria. Yesterday, Bloomberg ran a feature entitled, “Emerging-Market Stocks to Gain Further After 52% Rally This Year.”
But make no mistake. This is a classic case of investors chasing performance. Such a strategy always fails. Or as Humphrey Neill put it in The Art of Contrary Thinking, “When everyone thinks alike, everyone is likely to be wrong.”
Don’t be everyone.

Instead, consider selling short the MSCI Emerging Markets Index Fund (EEM: 36.53 +0.36 +1.00%).Or at the very least, check your asset allocation.
If you’ve got more than 20% of your portfolio in emerging markets, you could be in store for a nasty setback. To avoid it, I recommend you take some profits off the table while you still can.