India, China Get Blitzed

The major Asian markets dropped several percent today, India's key Nifty Index giving up more than 2% to go along with major losses in China.

For people who have been following along on my Motley Fool Global Gains tour of these countries, you'll know that I'm on the ground in Hyderabad, India, looking at companies as well as the overall environment for potential investment recommendations for our small-cap service. These types of drops do two things at once -- one good and one bad. On the one hand, some of the veneer in these incredibly fast-growing countries, where there's a lower level of overall investing risk, is being ripped away. Certainly, with the Chinese market up more than 40% this year following a 130% increase in share prices last year, it's been easy to get swept up in the euphoria.

There are more people in China with brokerage accounts than there are members of the Communist Party. Brother Mao would be gobsmacked.

The downside is that, in many cases, people will simply give up on trying to invest in these areas. I mean, it's fine for people who know that even highly valued markets contain bargains, but as is always the case, many people are too interested and too heavily invested at the worst possible times -- and they are repelled by the markets at the times when the most bargains are available.

Here in India, we've been having some fascinating discussions that mirror some of the challenges going on in China. India's markets are absolutely awash with liquidity. The total invested in Indian mutual funds, for example, rose by 16% in the month of May alone. By the same token, shorting stocks and other instruments in India is illegal, which means that all of this new investment money can only be exposed to the long side in the Indian market.

Everyone has an interest in talking up the book of Indian stocks. Everyone. If there's no way to short Wipro (NYSE: WIT), WNS (NYSE: WNS), or VSNL (NYSE: VSL) in India, then who in the world would have the incentive to talk them down? I mean, even if they should be?

I don't happen to believe that the Indian stocks writ large, including these companies, are overvalued, but wouldn't it be better if the mechanisms that are best at keeping stocks from becoming overly buoyant were allowed to work? Would Chinese housewives be plowing their money into garbage-quality companies at absurd multiples if there was someone there to say "Hold on just a minute"? Again, the Chinese market has taken such strides toward transparency (with enormous strides to go) that I don't necessarily think the top-quality companies like New Oriental (NYSE: EDU), Ctrip.com (Nasdaq: CTRP), and PetroChina (NYSE: PTR) have much to worry about long-term. But a shaky Chinese market can't help but roil their investors. And that's a shame.

The trouble is, the market can only follow the popular vote for so long. Companies, and their profits and cash flows, ultimately determine where stocks will go. This is an inalienable principle. The lack of downside protection options and the rush of liquidity is going to produce quick booms and busts. The government regulators are concerned about volatility if they legalize short-selling. I personally think they get more of that by keeping it illegal. The same conversation is ongoing in China -- they're afraid that by allowing shorting and derivative products to come on the market, they're going to signal that it should drop.

Well, if stocks are overvalued, they should drop. It is far more destabilizing the longer they don't, as the Indians should be able to appreciate following the massive drop in the markets here last May.

Global Gains advisor Bill Mann is currently traveling in China, India, and Taiwan in search of new investment opportunities in these fast-growing economies. Get his updates and analysis live from the field by sending Bill an email at BillTrip@Fool.com.

Bill Mann owns none of the companies mentioned. New Oriental is a Global Gains pick. Ctrip is a Hidden Gems recommendation. The Fool has a disclosure policy.