First boom, then bust: Investors once keen on emerging market darlings are now in full flight

International Investing Associated Press

If you think investors in U.S. stocks have had it rough, consider the hapless folks who followed Wall Street's advice to buy emerging market stocks.

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The MSCI Emerging Market index has lost 25 percent over the past year, while the mostly widely held U.S. fund, the Vanguard Total Stock Market index, is down less than 1 percent.

After the financial crisis, plowing money into emerging markets seemed like a sure bet. China was gobbling up raw materials from Brazil, Indonesia and Russia, and their stock markets were soaring. Wall Street cranked up its marketing machine, creating 246 funds to ride the boom.

"Whatever is hot, Wall Street will race out with new products to catch the investor's eye," says Larry Swedroe, head of research at Buckingham Asset Management. The blitz worked. In the five years through 2013, investors poured $104 billion into emerging-market stock funds, more than quadruple the amount of money in these funds.

Now, in classic fashion, investors are reversing course: They've yanked $40 billion from emerging-market stocks this year, a record pace of withdrawals, as a slowdown in China has hammered companies that supply raw materials. But the selling has also created real value, some savvy investors say. It costs half as much to buy a dollar of earnings from emerging market companies now than it does to buy a dollar of earnings from U.S. companies.

The zigzagging fortunes of emerging markets reveal the pitfalls of chasing the hot new thing, and how the best time to buy may be precisely when everyone else is selling.

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EMERGING STOCK FUNDS

Betting on emerging markets has never been for the faint of heart. Values soar as money floods in from investors hoping to profit from rapid economic growth. Along comes a crisis, currencies collapse and inflation spikes. Values plummet and money rushes out.

Why they're falling now: Fear that Chinese demand for Brazilian steel, Indonesian coal, Chilean copper and other goods could slow further. Sliding currencies in these countries squeeze companies trying to pay back loans taken out in dollars. Memories of the 1997 Asian financial crisis aren't helping. Back then, investors fled Thailand, Indonesia and other Asian tigers, and the fallout threatened to spark a global recession.

Why investors may be wrong: Companies in developing countries have taken out more loans in their own currencies, so they're better prepared when their currencies fall against the dollar. Manufacturers in South Korea and Taiwan, for example, import a lot of raw materials, so they benefit from falling commodity prices. And many big Indian companies rely on local customers, providing banking services and consumer goods to the country's swelling middle class.

The value case: It will cost you $13.23 to buy a dollar of their average annual earnings over the past decade, less than the $14 it cost during the panic selling of the 2008 financial crisis, according to Chris Brightman, chief investment officer at Research Affiliates. Before that crisis, investors paid $35 for a dollar of earnings, nearly triple the price now.

The problem is, prices could get cheaper still. Brightman warns that investors tend to overshoot during busts, just as they do during booms, because they think "what is happening currently will go on forever."

COMMODITY FUNDS

The drops are stunning. Oil falling by more than half in the past year, iron ore plunging by a third, coal and copper off by more than a quarter. Even prices for wheat and corn — people can't stop eating, can they? — have fallen by more than half in two years.

Pimco's largest raw materials fund, the Commodity Real Return Strategy fund, has lost a third of its value over the past year. That's after a rocky ten years, during which the fund rocketed as high as 30 percent and plunged as much as 60 percent.

Why they're falling now: Too many companies pulled too much out of the ground before the financial crisis. China's massive stimulus program fueled even more drilling and digging. With the big investments already made, companies figure they might as well keep pumping oil and extracting ore. Investors speculate that supply may overwhelm demand for a long time yet.

Why investors may be wrong: Small drillers and miners are starting to go out of business as prices fall below their cost of production. That should ultimately squeeze supply, and lead to prices stabilizing.

The value case: The commodity glut is hardly a secret, so prices may already reflect it. Market strategists at Northern Trust wrote in a recent report that prices are looking more compelling, and recommended that investors consider the Morningstar Global Upstream Natural Resources fund, which contains 120 commodity producers. They like the fund's exposure to food giants such as Bunge and Archers Daniels Midland. It's not for the timid, though. The fund is in the middle of a three-year losing streak, capped by a 19 percent drop in the last three months.

In fact, these investments may need five to 10 years before they become truly attractive, says Rudolph-Riad Younes, a portfolio manager at R Squared Capital Management. Buying now is "a loser's game."

EMERGING MARKET BONDS

Enticed by higher interest rates than in the U.S., investors plowed into emerging market bond funds in the aftermath of the 2008 crisis. Warnings that the U.S. government would struggle to pay its rising debts added to their appeal. Governments in Brazil, Turkey and other developing countries had scaled back their borrowing, and with their economies expanding rapidly, it seemed they would have no trouble making their payments. In the four years after 2008, the amount of money these bond funds had at their disposal tripled to $77 billion.

Why they're falling now: Brazil and Russia have fallen into deep recessions, and emerging market currencies have plunged around the world. The sorry history of emerging markets suggests a wave of corporate defaults, a jump in inflation and rising political instability as anger spreads on the streets. After the Asian financial crisis, student protests in Indonesia, one of the hardest hit countries, helped depose the country's ruler after three decades in power.

Why investors may be wrong: These countries are better prepared for financial shocks. They have lower debt burdens than many developed countries, and have built up foreign reserves to defend their currencies. "You would have seen social instability and bank runs" in previous years, says Samy Muaddi, a portfolio manager at T. Rowe Price. "But that's not happening today. I take it as a positive sign."

The value case: Just 2.3 percent of emerging market companies that rating agencies consider the riskiest missed a payment so far this year. That's just a hair above the 2.2 percent default rate for similar U.S. companies. That default rate could jump, of course, but investors get paid more to take that risk. According to Barclays Capital, emerging market bonds yield 5.7 percent, a full percentage point higher than a year ago.