Newsflash: Emerging Markets Aren't Safe Havens

For the second time in recent weeks, I read a headline from a reputable financial news service 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 this year.

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 of the Vanguard Emerging Markets Index from 2003 to 2007:

2003

2004

2005

2006

2007

58.8%

26.7%

32.9%

29.7%

39.4%

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 -- Petrobras (NYSE: PBR  ) , Vale (NYSE: RIO  ) , and Sohu.com (Nasdaq: SOHU  ) all gained more than 500%.

By comparison, a number of formidable U.S. large chips, including Pfizer (NYSE: PFE  ) , Dell (Nasdaq: DELL  ) , and Kraft Foods (NYSE: KFT  ) , 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.

Index (Country)

YTD Performance

Shanghai Composite (China)

(60%)

Bombay (India)

(42%)

RTS (Russia)

(63%)

Source: Yahoo! Finance.

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."

For one, 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.

For another, high inflation has always been a major issue in emerging markets. While the current U.S. inflation rate is nothing to cheer about, it's much better than the going rates in emerging markets. In 2008 alone, inflation sits at 18% in Pakistan, 17% in Egypt, 14% in Russia, and 30% in Venezuela.

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 Merrill Lynch, emerging markets now trade for an average price-to-earnings ratio of 11.4, the lowest level since September 2001, which turned out in hindsight to be an excellent time to load up on emerging-market stocks.

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 115,000-plus members supports this research idea. The following emerging-market ETFs currently receive CAPS' maximum five-star rating  -- and our data has shown that five-star stocks as a group have thus far gone on to outperform the market.

ETF

Top Holding

Vanguard Emerging Markets (VWO)

Gazprom

SPDR S&P Emerging Middle East & Africa (GAF)

Teva Pharmaceutical (Nasdaq: TEVA  )

iShares S&P Latin America 40 Index (ILF)

Vale

WisdomTree Emerging Markets Small Cap Dividend (DGS)

Growthpoint Properties

iShares MSCI Brazil Index (EWZ)

Petrobras

Sources: Motley Fool CAPS as of Oct. 6, 2008, 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, which launches today, we'll be 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 enter your email address below.

Todd Wenning is a Motley Fool Pro analyst and a huge fan of kettle corn. He owns shares of Pfizer, but of no other companies mentioned. Pfizer, Petroleo Brasileiro, and Kraft Foods are Motley Fool Income Investor selections. Pfizer and Dell are Motley Fool Inside Value recommendations. The Fool's disclosure policy tells it like it is.


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