Emerging Markets Run Up the Score

07/02/2009 11:13 am EST

Focus: GLOBAL

Igor Greenwald

Chief Investment Strategist, MLP Profits

In the final of a soccer tournament on Sunday, the US team held a 2-0 lead on Brazil before the favorites stormed back with three second-half tallies to steal the game and lift the cup.

This was a familiar script to players in the investment arena as well. In the second half of 2008, the Standard & Poor’s 500 fared considerably better than the all-but-defenseless emerging markets. It shed 29% June to December, scoring fewer own-goals than the upstarts, which lost 54%.

But this year has been a whole new ballgame. The 1.8% gain by the S&P over the last six months looks positively pedestrian next to the 34% surge in the MSCI Emerging Markets Index. Emerging Latin America has paraded 43% higher so far this year. So while the US still clings to a narrow lead over emerging markets since the end of 2007, there's no doubting the recent overseas momentum.

Shanghai stocks kicked off the second half of the year by sprinting 1.7% to a 13-month high, as Chinese industrialists clung to cautious optimism. Meanwhile, their Japanese counterparts remained down in the dumps. All the same, the Nikkei has emerged from its late-June dip without any damage to its recently bullish chart. After being down so long (75% since 1990), it's bound to catch a break one of these years. Some pundits now suggest this is the one.

But are investors mad to keep plowing money into hotter markets that, in some cases, are up by more than 50% from their lows? That depends crucially on whether those panic lows were any more rational than the current numbers—and it would seem they weren't.

None other than Alan Greenspan last week championed the notion that the stock rally is not merely anticipating better economic growth but is in fact helping to bring it about, as the emotional swing from dismay back to hope boosts share prices, restores corporate balance sheets, and ultimately propels investment. Greenspan's eventual point was to warn about future inflation, though the Maestro's musings on this score must be judged in light of a housing bubble that inflated on his watch and burst just as he was promoting his memoir.

Stocks catering to Chinese consumers have been on fire for a while now. Notably, American Dairy (NYSE: ADY), a Chinese milk powder supplier, has frothed 346% in a year's time. It is a testament to the opportunities in the Chinese market that the stock's valuation metrics are still palatable. They've caught the fancy of Paul Goodwin, editor of Cabot China & Emerging Markets Report, though he recommends giving the stock time to settle down before committing funds.

David and Eric Coffin are also wary of potential downside, though in this week's global perspectives excerpt they call the recent shows of strength in Shanghai and Mumbai "another aspect of the new world order that is now evolving."

So, what about the Old World, sentenced by most pundits to stagnation if not worse as it feeds on scraps from investment flows into healthier markets? Here, too, it may pay to think small. Andrew McHattie points readers of Investment Trust Newsletter towards two small-cap UK trusts now yielding more in dividends than gilts (UK government bonds) do in interest. The implication is that these companies' growth prospects have been discounted to zero, undeservedly. In an encouraging contrast to ADY, these trusts don't seem to have attracted much hot money.

China and India clearly have. But in the aftermath of a shock like we've had, it's easy to forget that hot money can heat asset prices for a good long while. Bond guru Bill Gross speculates that investor greed may not return for "at least one generation." I'd take the under on that line.

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