Posted by on Jul 28, 2009 in Blog, Columns, Featured |

Image Credit: Heath Hinegardner

By Jason Zweig | July 25, 2009 11:59 p.m. ET

Behind the world’s hottest markets is a cold truth many investors don’t want to hear.

Emerging markets — those developing countries that used to be called “The Third World,” like Chile and China, Turkey and Thailand, Brazil and India — have been hotter than a potful of habanero peppers. The MSCI Emerging Markets index has gained 45% so far this year, versus 9% for the U.S.

And investors have noticed, pouring $10.6 billion into emerging-markets mutual funds so far this year, or more than 34 times the total they added to U.S. stock funds. The iShares MSCI Emerging Markets Index Fund is now the fourth-biggest of all exchange-traded funds, with $30.8 billion in assets.

Investors hope to capture the stunningly high growth of the developing world, especially with the U.S. economy shriveling. In the second quarter of 2009, China’s economy officially grew 7.9%, while the U.S. likely contracted about 1.5% in the same period. For all of 2009, Barclays Capital forecasts, the developing economies of Asia will grow 5.2%, while U.S. gross domestic product will shrink by 2.3%.

Unfortunately, high economic growth doesn’t ensure high stock returns. “People have hopelessly got the wrong end of the story,” warns Elroy Dimson of London Business School, who is one of the world’s leading authorities on financial markets.

Based on decades of data from 53 countries, Prof. Dimson has found that the economies with the highest growth produce the lowest stock returns — by an immense margin. Stocks in countries with the highest economic growth have earned an annual average return of 6%; those in the slowest-growing nations have gained an average of 12% annually.

That isn’t a typo. Over the long run, stocks in the world’s hottest economies have performed half as well as those in the coldest. When Prof. Dimson presented these findings recently in a guest lecture at a Yale University finance program, “a couple of people just about fell off their chairs,” he says. “They couldn’t believe it.”

But, if you think about this puzzle for a few moments, it’s no longer very puzzling. In stock markets, as elsewhere in life, value depends on both quality and price. When you buy into emerging markets, you get better economic growth — but, at least for now, you don’t get in at a better price.

“It’s not that China is growing and everybody else thinks it’s shrinking,” Prof. Dimson says. “You’re paying a price that reflects the growth that everybody can see.”

In other words, economic growth is high, but stock valuations are even higher. In 2008, as U.S. stocks fell 37.6%, emerging markets crashed 53.3%, according to MSCI. At year end, emerging-markets stocks traded at a 38% discount to U.S. shares, as measured by the ratio of price to earnings. Now that both markets have bounced back, emerging markets are at only a 21% discount. And make no mistake: They should be much cheaper than U.S. stocks, because they are far riskier.

“The logical fallacy is the same one investors fell into with Internet stocks a decade ago,” says finance professor Jay Ritter of the University of Florida. “Rapid technological change doesn’t necessarily mean that the owners of capital will get the benefits. Neither does rapid economic growth.”

High growth draws out new companies that absorb capital, bid up the cost of labor and drive down the prices of goods and services. That is good news for local workers and global consumers, but it is ultimately bad news for investors. Last year, at least six of the world’s 10 largest initial public offerings of stock were in emerging markets. Through June 30, Asia, Latin America, the Mideast and Africa have accounted for 69% of the dollar value of all IPOs world-wide. Growth in those economies will now be spread more thinly across dozens of more companies owned by multitudes of new investors.

The role of emerging markets, says Prof. Dimson, “is to provide diversification, not to add to returns.” Having up to 15% of your total U.S. and international stock assets in emerging markets can make sense. But before you jump in with both feet, look at the holdings of the international funds you already own; many keep at least 20% of their assets in developing markets.

Like all performance chasing, this latest investing binge is doomed to disappoint the people who don’t understand what they are doing.

Source: The Wall Street Journal