End of the Line for Emerging Markets?

As we suffer through the end of the second year of recession in the U.S., it's hard to remember that in some parts of the world, the global slowdown hasn't been nearly as evident as it is here. Yet in countries where economic prospects look a lot brighter going forward, investors would do well to remember that stock markets don't go up in a straight line -- and eventually, even red-hot investments cool off.

Pedal to the metal
From a macroeconomic perspective, things are starting to look better throughout the world. According to figures compiled by The Economist, GDP growth is expected to return in 2010 to the U.S., Japan, and Europe's major economies, as most countries recover from contracting economic output this year.

Yet several regions never experienced much of a slowdown at all. In particular, China, India, and Indonesia saw minor drops in the rates at which their GDPs were growing, but those growth rates still dwarf what most of the rest of the world is hoping to see, even after the global economy recovers. Brazil saw a significantly greater slowdown, but the South American powerhouse will likely jump back to strong growth in the coming year.

The stock market disconnect
As dreams of a brighter economic future seem to move closer to a reality, you might expect to see stocks in these booming areas continue the breakneck advances they experienced earlier this year. Over the past couple of months, however, even emerging markets have seen their stock gains slow down. That might be a sign of an imminent correction ahead.

In particular, look at how some fairly well-known stocks among the emerging markets have been doing more recently:

Source: Morningstar, Yahoo! Finance. As of Dec. 23.

You can see from this small sample how emerging-market stocks have entered a period of consolidation. Whether individual companies jumped strongly or missed out on the rally, many stocks have stopped rising over the past couple of months. And even when you broaden your outlook to examine entire markets, rather than particular stocks, you can see the same clear signs of a small pullback -- one that could grow larger in 2010, as investors take advantage of the new year to take profits without affecting their 2009 tax bills.

The right move right now
Any time you think about selling, you need to ask another question at the same time: What will you do with the proceeds of your stock sale? Recently, a commentary in Barron's suggested that investors were starting to give up their obsession with emerging-markets investing in favor of U.S. stocks in the small- and mid-cap space. Given the gains that stocks like JDS Uniphase (NASDAQ:JDSU) and Green Mountain Coffee Roasters (NASDAQ:GMCR) have seen this year, that's not surprising.

Yet while small domestic companies certainly have attractions of their own, you shouldn't see a more significant pullback in emerging-markets stocks as a signal that you should sell all your holdings. Regardless of the short-term fluctuations in stocks, those economies have solid fundamentals that are likely to shine through in their long-term market prospects for decades to come.

It'd make more sense to take a close look at your international exposure and make sure it's in line with where you want it to be. After a year of huge gains, you may find yourself with a far greater share of your overall assets invested in emerging markets than you intended. Taking profits to restore a comfortable risk level in your portfolio makes a lot of sense, especially right now after the big rally in stocks.

Think long-term
From the big-picture angle, though, the long-term key is whether emerging-markets economies can continue to grow at the rates many expect. If they do, then even a substantial correction may simply look like a brief hiccup compared to the returns ground-floor investors earn by sticking with their emerging-markets investments.

Tim Hanson feels like a kid in a candy shop. Find out what he's picking as the best stocks to buy today.