News Flash: Emerging Markets Aren't Safe Havens

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As global markets plunged last October, I read multiple headlines from reputable financial news services lamenting that emerging markets are no longer "safe havens."

Maybe I missed the memo -- safe? seriously? -- but anyone who considered emerging markets safe havens received a rude awakening in 2008.

Ravishingly rude?
It's true that for the past five years, emerging markets may have appeared invincible. China grew its economy at double digits each year, the Indian tiger economy roared, and Russia and Brazil capitalized on their abundant natural resources.

Just consider these incredible returns for the Vanguard Emerging Markets Index from 2003 to 2007:

2003	2004	2005	2006	2007
57.7%	26.1%	32.1%	29.4%	38.9%

Source: Vanguard.com.

With five straight years of returns north of 25%, it's understandable that investors may have become overconfident about the relative safety of emerging markets. For a while there, you could stick a dollar in an emerging-markets fund, experience limited volatility, and leave a year later with $1.30 or more. If that doesn't give the illusion of being "safe" (and profitable), I'm not sure what does.

As you might expect, some individual emerging-market stocks did even better than the index during this five-year period -- America Movil (NYSE: AMX), China Mobile (NYSE: CHL), and ArcelorMittal (NYSE: MT) each gained more than 500%.

By comparison, a number of formidable U.S. companies, including Wal-Mart (NYSE: WMT), Eli Lilly (NYSE: LLY), and Bed Bath & Beyond (Nasdaq: BBBY) lost money during this bull market, making the go-go emerging-market stocks look all the more attractive.

But then a funny thing happened in 2008: Emerging markets fell back to reality, along with most everybody else. The Vanguard Emerging Market fund lost 52.8%.

Oops!
Look, the growth of emerging-market economies this century has been awe-inspiring, and these markets will undoubtedly produce some of the market's best stocks of the next 10 years, but it's unwise to ever think of them as a "safe haven."

Even though no stock is technically "safe," emerging-market stocks present additional political, currency, and country risks that make them even more volatile than stocks based in developed markets.

None of these risks were unknown before 2003, but emerging markets performed so well for a stretch that investors may have chosen to ignore them while they chased huge returns.

What goes up ...
But just because they aren't "safe" doesn't mean you should ignore emerging-market stocks -- especially now. According to a report in December from Fidelity, emerging markets currently trade with single-digit trailing price-to-earnings ratios, marking historical lows.

While you shouldn't necessarily expect another five years of huge returns from emerging markets, now's a great time to give them a second look -- or a first look.

Our Motley Fool CAPS community of 125,000-plus members supports this research idea. The following emerging-market exchange-traded funds receive four- and five-star CAPS ratings -- and our data thus far has shown that four- and five-star stocks as a group have gone on to outperform the market.

ETF	Top Holding
iShares MSCI Chile Index (ECH)	Enersis (NYSE: ENI)
iShares MSCI Singapore Index (EWS)	Singapore Airlines
WisdomTree Emerging Markets Small Cap (DGS)	Wan Hai Lines
iShares S&P Latin America 40 Index (ILF)	America Movil
SPDR S&P Emerging Middle East & Africa (GAF)	Teva Pharmaceutical

Sources: Motley Fool CAPS as of Jan. 2, 2009, and Morningstar.

Foolish bottom line
Despite the volatility and the inherent risks associated with emerging-market stocks, they should still have a place in your portfolio. We've only seen the beginning of the growth potential of markets like China and Brazil -- and if you've only just caught on to these markets, you haven't had the opportunity to invest in them at value prices. Thanks to the market decline we've experienced in the past year, emerging-market stock valuations have returned to value territory.

At our new Motley Fool Pro investing service, we've been using CAPS to sort through that value, identify strong and weak sectors, and identify specialized ETFs that will help us go long or short on those positions. Armed with $1 million of the Fool's money, we're building a portfolio designed to deliver superior returns in any kind of market. If you'd like to learn more about Motley Fool Pro, just put your email in the box below.