Hard to leave foreign stocks

Emerging-market shares up 36%, but some see bubble about to pop

October 14, 2007|By Gail MarksJarvis | Gail MarksJarvis,Tribune Media Services

You have to love emerging market stocks. After all, they are up more than 36 percent for the year, an even more tantalizing return than the 31.6 percent average for each of the past five years.

But should you love them and leave them?

Analysts are starting to use the word bubble for emerging market stocks. Yet many are telling investors it's still not time to bolt. They urge investors to watch stock valuations and performance, along with the prospects for inflation or recession, to help determine where stocks are likely to be headed.

Many are suggesting that investors continue to partake in the momentum as emerging markets benefit from another round of easy money from the Federal Reserve's recent rate cut, plus a tendency by global fund managers to chase growth-spurt countries from Asia to Latin America.

But they are warning that easy money and momentum work two ways - inflating stock prices at first but sometimes causing manias that go too far, and end badly.

Merrill Lynch analyst Michael Hartnett summed it up in a recent report when he wrote: "Can the emerging bull market continue? Yes." But he added that investors must remain attentive. "An asset bubble seems likely, led by BRIC markets," he wrote, referring to Brazil, Russia, India and China.

Typically, emerging markets fell harder than developed markets as investors fled stocks in July and August amid concerns about the impact of the U.S. subprime bond mess on the worldwide financial system.

While the Standard & Poor's 500 dropped 9.4 percent, emerging markets lost 14.4 percent. Yet, as fear subsided, emerging market stocks sprang back powerfully, gaining 25 percent since Aug. 19.

For the year, the MSCI Emerging Market index is up nearly 37 percent, and the S&P/Citigroup Latin America index is up 49 percent. Developed markets - including the United States, Europe and Japan - have been no match. For the year, the U.S. S&P 500 is up about 10 percent. Japan has limped along at roughly 2 percent.

The emerging markets, which provide commodities to the world and also consume them as they build highways to housing for a growing middle class, have followed the trend in commodities prices. For the year, energy stocks are up 27 percent, and materials are up 23 percent, according to S&P.

Analysts say that if countries such as China and India continue their tremendous growth and the United States avoids a recession, the prices of emerging market stocks are not out of line. But they are starting to reach levels that are making some analysts cautious.

"As the current up leg in emerging market share prices continues to gain momentum, it is time to ask what will cause the next shakeout," BCA Research said in a recent report.

Typically, emerging market stocks - measured by prices compared with their earnings - have sold at a discount to stocks in developed countries because of the added risk. But that is no longer true.

They are running neck and neck now, with emerging stocks about 13.3 times earnings, compared with 13.4 times for developed countries, said Todd Henry, an emerging market portfolio specialist at T. Rowe Price.

With stock prices on emerging stocks that high, there is extra risk for investors, he says.

"There isn't a lot of room for disappointment," he said.

Stocks could fall significantly if earnings growth doesn't materialize as expected. And growth worldwide is slowing. Earnings in emerging markets are expected to climb 14 percent this year, compared with 41 percent in 2003. For developed countries, this year's estimate is 8 percent, compared with 19 percent in 2003.

Henry notes that the position of emerging market stocks is opposite that in the early 2000s. Then, the stocks had been ignored for years. During the five years up to 2001, they had climbed only about 1 percent a year, in part because they were so cheap that they soared so powerfully during the next five years.

Rather than being attracted by prices climbing 40 percent now, Henry says "that's a bit of a sign, a red flag."

Still, whether investors should flee or stick this one out depends on the type of investors they are. Henry notes that T. Rowe Price growth fund managers, which take on risk, are weighting emerging market stocks heavily, at close to 25 percent of international portfolios.

Value managers who avoid stocks when they become expensive and risky have reduced emerging market exposure significantly.

But Henry and other analysts are warning investors who want to ride the momentum further to do it with their eyes open.

If investors see a threat of a U.S. recession, he said, emerging markets could drop 25 percent. If they continue to ride the wave and values climb another 20 percent by the end of this year, Henry warns, they could be in a precarious position.

Hartnett is issuing a similar warning. But he thinks ultimately the threat to emerging markets will be inflation rather than recession.

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