Emerging Markets are Emerging

As reported at Shocked Investor, Ernst &Young have published a list of the top 100 companies in the world, ranked by market capitalization. In 2009, 18 of the 100 came from emerging markets in 2009, up from 11 in 2008.

The ten largest are revealing. Three of the top 5 are U.S. companies and two are in China. Overall, emerging markets outrank the U.S. in the top ten. The U.S. has four companies - Exxon (XOM), Microsoft (MSFT), Walmart (WMT) and Google (GOOG) - while five come from China, Hong Kong and Brazil. The other top ten company is from Australia. (Hat tip to Phil's Stock World.)

In a related article, Peter Trasker at ft.com offers cautions about the risks of investing in emerging markets. The article is entitled ”Busting the Myths of the BRICs” and particularly focuses on China. Among other things Trasker cites studies that show that GDP growth correlates poorly with stock market performance. He cautions investors not to assume that rapid GDP growth in China will necessarily produce further stock market gains there in the near future.

Trasker says that valuation is a much better indicator of future stock market performance. Low valuations correlate with better future stock market performance and higher valuations with poorer returns. He compares stock valuations for China in 2007 with the top of the Japan bubble in 1989. He also compares China's real estate market to Tokyo's valuations at the peak. We all know what has happened to Japanese stocks and real estate since 1989.

What Trasker fails to discuss in his article are the differences between Japan in the 1980s and China in the 2000s. First, Japan was a maturing economy then and China is still emerging now. A most important difference is in demographics. Japan had limited access to low cost domestic labor and China still has hundred of millions not yet assimilated into the labor market. There is a vast potential domestic consumer market needed for organic growth in China which Japan did not have 20 years ago and still does not have today. China is also better situated with respect to natural resources and energy than was and is Japan.

There is much recent debate about China. Two recent articles present opposing sides of the debate about investing in China. Market Folly reports on Jim Chanos giving reasons that China is in a bubble and Shaun Rein explains why he believes there is no China bubble . Today (Wednesday, 1/13/10) Thomas Friedman asks in The New York Times ”Is China the Next Enron”. Friedman is quite skeptical that the answer is yes. Two others I follow have recently published negative outlooks for China: Reggie Middleton and Edward Harrison.

Investing in emerging markets are high risk ventures. Investing in the U.S. is also high risk, as investors have come to realize to their dismay. The following graph compares the stock market performances of Brazil, China and the U.S. since September, 2007.

Obviously, all three markets suffered mightily in the global financial crisis. The relative poorer performance of the Shanghai and, looking only at the decline, Brazil markets is evident in the following table. We thought the rate of decline of the U.S. market was precipitous, but both Brazil and China fell at much faster rates.

I am investing cautiously in both China and Brazil, using the ETFs iShares MSCI Brazilian Index (EWZ) and iShares FTSE/XinhuaChina 25 Index (FXI). I have such tight stop loss risk management on both positions that I am clearly trading both ETFs, rather than investing. The strategy is described in my winter contrarian trading portfolio published at The Street.com.

Brazil and China are not the only hot emerging markets. The following table shows where emerging market ETFs rank within the 100 top performing funds for the trailing 6 months as of January 13, 2010. Data is provided by the ETF Digest . Emerging market ETFs are 24% of the top 100 and 33% of the top 73 non-leveraged funds.

There are two ranking columns because 22 of the top 27 performing funds are leveraged. The ranking among non-leveraged funds only is given in the last column. The table is presented in two images because of size limitations.

Australia, Sweden and the Netherlands have been included in the table even though they are not considered emerging market countries. Note that FXI, which has gained 16% in the past six months, does not appear on the top 100 list.

Just remember when you look at the list, emerging markets can be fickle lovers. They can be hot one day and dumping you the next. In case you have forgotten, just go back in this article and look at the 115% annual rate of loss for Brazil and the 70% annual rate of loss for China compared to 40% annualized loss rate for the S&P 500.

Disclosure: Long EWZ and FXI.