IN THE LONG term, the case for emerging markets remains strong," The Economist magazine said in February 1997. Just how long, of course, was unknown and unsaid, but a few months later currencies, governments and stock markets started crashing across the Third World, prompting years of terrible investment returns.
Now, eight years later, many investors seem to believe the long term has arrived. The Morgan Stanley Capital International emerging markets index hit 623.49 last week, an all-time high, more than twice its level of early 2003 and well north of the 571 peak reached in July 1997, before the plunge.
Improved trade balances, better corporate governance and growing middle classes in places such as India and Brazil have inspired hope that perhaps, this time, emerging stock-market investors won't reap amazing returns only to see them disappear a year or two later.
But they may be disappointed. Yes, risks such as inflation and rickety currency setups have diminished in developing nations. But buying stocks in places such as Turkey or Thailand is still inherently dicey.
Corruption is diminished but still deeply rooted in many parts of the developing world. Capital allocation is still inefficient. Countries seem to be overbuilding car factories and other manufacturing capacity again. And the flood of money let loose by Alan Greenspan to help the planet recover from the burst 1990s bubble, a key factor in the rise of emerging market stocks as well as U.S. housing prices, is rapidly drying up.
"All these funds have been hot for several years now," Morningstar analyst William Rocco says of emerging-market mutual funds. So hot, he says, that "people are considering Egypt now and other markets that they weren't considering years ago."
Through June this year, investors sank $5 billion into U.S.-based mutual funds that invest in emerging markets, according to the Investment Company Institute, the mutual fund trade outfit. That's more than emerging fund inflows for all of last year and nearly 10 times as much as for all of 2002.
Propelled in part by all the new money, stocks in many developing countries have produced amazing returns.
The above-mentioned Egyptian stock market (sample companies: Sinai Cement and Vodafone Egypt) is up 150 percent since last summer. Jordan is up 180 percent, and Slovakia is up 140 percent. (Not Slovenia. It and Nigeria are almost alone among emerging nations whose stock markets have fallen in the past 12 months.)
Counting reinvested dividends, the broad MSCI emerging markets index has returned 170 percent since just after the Sept. 11 terrorist attacks.
Market specialists say the stocks aren't just rising in a vacuum. In addition to more-flexible currency regimes and rapidly growing economies, they say, emerging markets boast companies that are increasingly well managed and able to grow profits. Soaring oil and commodity prices have helped, since many developing economies are based on natural resources.
"People always like to tout emerging markets, [saying] you can have twice the growth at half the price," says Todd Henry, who helps run T. Rowe Price's Emerging Markets Stock Fund from London. "The problem was, you had twice the economic growth, but you never had twice the earnings growth."
Now, he says, "You've got earnings growth in emerging markets that has been very strong. You really are seeing better corporate governance."
The T. Rowe Price Emerging Markets Stock Fund has done especially well, returning 21 percent this year, doubling since early 2003 and earning Morningstar's "Analyst's Pick" for the category, along with Oppenheimer's Developing Markets Fund and American Funds' New World Fund.
The long-run case for emerging markets is still stronger than it was in 1998. Macroeconomic improvements such as better monetary reserves and the virtual absence of inflation have reinforced the argument that emerging economies grow much faster than First World ones and therefore should support rapidly rising stock markets.
Everybody wants to find the next Japan, which bolted from developing to developed in a few decades and allowed patient stock investors to multiply money a hundredfold between the 1950s and the 1980s.
But bringing billions of people out of poverty, which is what we're talking about, is the stuff of history, and history rarely evolves in a straight or comfortable line. Laws protecting property rights are still perilously thin in numerous growing nations. The free trade that supports Third World growth is threatened by protectionists. And Greenspan, by raising short-term interest rates, is removing the punch bowl.
We've been bullish on developing nations before, only to be let down. Past performance is no guarantee of future results, but sometimes it gives a good idea. Don't dump your whole stash into emerging markets.