This Market Double Is No Bubble

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Lately, it seems like every time an investment makes money, you can find someone claiming there's a bubble about to burst. Yet although some stocks have recently enjoyed nearly unparalleled historical gains, you shouldn't rush to the conclusion that there must be a bubble inflating -- or even if there is, that it's going to pop anytime soon, sending shares plummeting back to earth.

Are emerging markets bubblicious?
The latest investments to gain the attention of bubble fanatics are emerging-market stocks. An article in The Wall Street Journal over the weekend noted how an ETF that focuses on Brazilian stocks has nearly tripled in size to almost $11 billion in just the past year. That surge stems from a combination of a Brazilian stock market that has doubled so far in 2009, and performance-chasing investors who've dumped $2 billion of new money into the fund. The ETF's two biggest holdings, Petrobras (NYSE: PBR) and Vale (NYSE: VALE), have gained 88% and 54%, respectively, since this time last year.

Nor is Brazil an isolated example. Again, according to the WSJ, investors have added $26 billion to emerging-market funds in 2009, with more than half of that going into ETFs. Given how well some of these markets have done, it's no surprise that they've attracted the full attention of those who follow the herd. Among Chinese stocks, China Life Insurance is up 76% in the past year, and Baidu (Nasdaq: BIDU) has risen 88%. In India, both Infosys (Nasdaq: INFY) and HDFC Bank (NYSE: HDB) are up more than 80%. And Russian funds have seen similar gains, with the Templeton Russia & Eastern European Fund up more than 60% year to date.

Are ETFs to blame?
Some cite ETFs as at least part of the cause of the huge rise among emerging markets. Since most ETFs own a fixed roster of individual stocks, high demand for ETF shares leads to corresponding demand for those particular stocks, leading some to conclude that "mindless" purchases are creating bubbles.

But there are a couple of reasons why you shouldn't rush to the conclusion that red-hot emerging markets are ripe for short-sellers to take advantage:

• More room to run. It's true that emerging markets have seen steep gains recently. But among many of the stocks and ETFs mentioned above, shares have actually fallen over the past two years on an annualized basis -- and in some cases, those losses are quite dramatic.
• We've seen this before. ETFs may be relatively new, but the idea that mechanical investing causes irrational bubble-like behavior isn't. For instance, S&P index funds got blamed in the late 1990s for pushing up shares of tech stocks like Cisco Systems (Nasdaq: CSCO) and Microsoft (Nasdaq: MSFT) to unsustainable levels, as their increasing market caps gave them greater weight in the index and led to big losses in the ensuing tech bust years from 2000 to 2002. George Soros likened the impact of commodity index funds on oil prices last year to what happened during the 1987 stock market crash.

Invest smarter
So how can you know whether emerging markets are overheated, or just at the beginning of a huge run? Instead of relying on your gut instinct, you can apply some of the same principles you'd use in picking any stock to investing in ETFs. Fundamentally, price alone can't tell you whether an investment is a good value; for ETFs, you also need to look at the earnings power of their primary holdings to see if their growth potential justifies their prices.

Similarly, attempting to determine the intrinsic value of major holdings can give you a better sense of whether an ETF gives you the desired margin of safety that will make you feel comfortable with investing your money in it. Other factors, including whether constituent companies pay dividends, have inordinate political risk, or face the loss of their competitive advantage, can also help you make a better decision.

It's way too early to conclude that Brazil and other emerging markets are in an inflating bubble. And more importantly, even when bubbles do happen, ETFs don't cause them; investors do. You'll always do better making your own decisions, rather than following the herd over the cliff. But if you find emerging markets compelling from a fundamental perspective, then don't assume that high investor interest in ETFs will inevitably sabotage your investment.