An opportunity to buy emerging-market stocks is likely to surface within a few weeks as nervous investors continue to flee from risky stocks, experts say. But analysts are warning investors not to be too eager to overindulge now.
With emerging markets down about 10 percent, analysts say it would not be surprising for the stocks to tumble another 10 percent or 15 percent.
Long term, they are confident that emerging markets--developing areas of the world in Europe, Africa, Latin America, the Middle East and Asia--will be among the world's most profitable investments. Yet that belief has powered the stocks to such high levels over the last four years that the stocks are expected to be vulnerable in the weeks ahead, especially if investors remain jittery about taking risks as they await the fallout from subprime mortgage loan defaults.
"The stocks have climbed about 300 percent in a few years, and that sharp of a run-up should make anyone pause," said David Darst, chief investment officer for Morgan Stanley's Individual Investor Group. "It take time for things to correct themselves."
While he is a firm believer in emerging-market stocks, he said he would be reluctant to buy until "people throw in the towel."
In a recent report to clients, Citigroup Latin America strategist Geoffrey Dennis warned investors of "emerging-market danger" and said either a threat to the U.S. economy or a "knee-jerk rise in risk aversion" could cause them to fall sharply.
Even without a shock, he noted, emerging-market stocks are trading at high levels compared with recent averages. Latin American stocks could fall 10 percent, and stocks from other emerging markets could drop 6 percent, just to go back to their 200-day moving averages.
Still, he noted, once they reach bottom, Latin America, developing Europe, Africa and the Middle East stocks as a group could climb 20 percent by the end of 2007.
Increasingly over the past few years, investment advisers have been urging clients to place a small portion of their portfolios into emerging-market stocks, using either exchange-traded funds or mutual funds. It is important, however, to keep an eye on those investments so that they do not become excessive, said Sandy Lincoln, chief market strategist for Wayne Hummer Asset Management in Chicago.
Lincoln said he often invests about 10 percent to 12 percent in international markets as a whole, including 2 percent to 4 percent in emerging markets.
"If a client in comfortable with 3 percent, and it goes to 5 percent, we pare it back," he said.
As for the people eager to get into emerging markets, Darst said he'd like to see an additional pullback, probably not 30 percent, but maybe another 10 percent to 15 percent.
Recently, investors have been fleeing emerging-market stocks and moving into safer global equity funds that invest throughout the world, concentrating on developed areas, including the United States.
During the second week of March, 84 percent of money flowing into stock funds was going into U.S. stock funds, especially Standard & Poor's 500 ETFs, according to EmergingPortfolio.com. Investors yanked money from Japan, China and Latin America.
Although investors adored emerging-market funds until the end of February, they pulled out $8.93 billion during the first week of March and then $245 million the next week, said EmergingPortfolio.com.
Investors were avoiding risk, worried that China intended to slow its economic growth, and also afraid that the subprime housing loan problem in the U.S. will cause banks to cut back on lending.
"There is evidence of tightening standards on consumer loans but not a general credit squeeze," Dennis said. "Either way, this may take time to play out."
Over several more months, the markets worldwide could be "vulnerable to more bad news," he said. He warned emerging-market investors to avoid thinking of defaults in risky U.S. home loans as a narrow market issue.
"The subprime mortgage sector [problems] would appear to be very domestic, almost parochial," he said.
Yet, he noted, global markets have been pummeled as news about mortgage problems has emerged, indicating the issue "needs to continue to be watched by emerging-market investors."
Although some concern has focused on the consumer, and the fear that their mortgage problems could cause them to cut back on spending, Dennis said the larger concern would be banks pulling back on lending. If both consumers and businesses have a more difficult time borrowing money, they could cut back on spending, impacting company profits and stocks globally.
Still, beyond those immediate threats, optimism about emerging markets is palpable.
Northern Trust senior investment strategist Alain Cubeles said: "Emerging markets are too big to ignore. They contribute nearly half of the world's economic activity and are growing at double the rate of developed-country economies."
In addition, about 85 percent of the world's population is living in emerging-market countries, and investors cannot afford to miss about 100 companies poised to become major multinational corporations such as Brazilian aircraft manufacturer Embraer and Mexican building-materials giant Cemex, Cubeles said.
Experts anticipate that the building and investment boom that has occurred everywhere from South Korea to Brazil eventually will put additional money into the hands of people throughout Asia, Latin America, developing Europe and Africa, spurring additional consumer buying.
"Consumption spending in the leading emerging-market countries is already $4 trillion, or 45 percent of the U.S. level," said Morgan Stanley analyst Jonathan Garner. And that spending has been growing at 7 percent a year.
Meanwhile, Garner noted that the surge in development is likely to continue for some time.
People are moving from rural areas into cities, and "companies are formed to take advantage of the opportunities arising from large customer bases," he said.
According to United Nations data, in 1950 some 730 million people lived in cities worldwide; by 1990, the number was 2.3 billion; and by 2015, it is expected to be 3.8 billion. That would put 73 percent of the world's population in cities, versus 41 percent in 1950.
"The overwhelming majority of urban population growth in recent years has been in the emerging world," Garner said.
Garner compares the movement of people into technological and industrial centers with the situation in the U.S. around 1848, the year Andrew Carnegie's family moved here from Scotland after their weaving skills no longer provided jobs in Europe.
"Andrew's first job was in a telegraph office, which he parlayed into employment as [a] telegrapher to the superintendent of the Pennsylvania railroad. The rest of his career was spent in the then `new' oil, steel and railroad industries," Garner said. "Such stories are taking place in the emerging world currently."
Meanwhile, Lincoln said investors need to be careful about getting carried away. Although the development surge is real, he said, emerging markets continue to be volatile and risky.
Although some analysts argue that a price-earnings ratio of about 13 makes emerging markets cheap relative to the U.S. market's average P-E ratio of about 16.7, Lincoln argues that investors should not pay the same price for emerging markets as for more stable countries with stronger banking systems, accounting and clear financial records.
"China's banking system is still nascent, and there is reason for people to be concerned," Lincoln said.
Also, when people buy emerging-market exchange-traded funds or mutual funds, they should be aware of the contents, Lincoln said. One very large holding in an ETF, such as South Korea, can take a sudden turn down, he said. For example, when news emerged that North Korea had run a nuclear test last fall, South Korean stocks dropped 4 percent, carrying ETF values down.
And because hedge funds are large holders of ETFs and are constantly buying and selling them, prices can plummet based on that alone.
Also, Lincoln notes when hedge funds are pouring money into the ETFs, the prices of those ETFs can be higher than the underlying stocks. In other words, people pay more for the stocks than they are worth.
Gail MarksJarvis is a Your Money columnist.