Slowing Down in Emerging Markets

Drew Brees may be the MVP of Super Bowl XLIV, but if the stock market rally of 2009 were to award a trophy for most valuable contributor, emerging markets would get the honor. While the S&P 500 Index posted a solid 26% gain last year, the MSCI Emerging Markets Index climbed an astonishing 79%. With sky-high returns come more attention and more inflows. But those investors who are blindly plowing into emerging markets now may be ignoring some red flags.

Warning signs
As much as emerging markets in general went up last year, some individual stocks brought even greater gains.

Source: Morningstar.

But don't assume that 2010 will be a repeat performance for some of these markets. In fact, there are some signs that certain highfliers may be encountering some headwinds in the near future.

Of course, the biggest story is China. This dragon has dominated headlines and many portfolios for some time now, thanks to its red-hot growth rate and still-untapped domestic and industrial potential. It has been the place for anyone who wants to cash in on the hottest ticket to emerging-markets riches.

But the Chinese market may be taking a breather. Inflation there rose to 1.9% in December, ahead of expectations, while gross domestic product came in at an amazing 10.7% in the fourth quarter alone. The Chinese housing market is also beginning to show signs of a bubble, with prices reaching eye-popping highs and consumers taking on highly leveraged loans to afford housing. All of this has helped to stoke fears that the government may tighten credit to try to rein in liquidity and cool the economy.

Caution ahead
Brazil is another powerhouse growth story that may be showing some signs of strain. There's no denying returns here have been off the charts -- the iShares MSCI Brazil exchange-traded fund (NYSE:EWZ) posted a chart-topping 121.5% gain last year. After such a huge run, stocks across the board there are much more highly valued and more risky than they were a year ago. Uncertainty about the presidential election in October could weigh on the market, as could any interest rate hikes, which the Brazilian Central Bank recently signaled were on the horizon. A cooling-off period and market correction is not out of the question for the Brazilian economy.

Ultimately, I think emerging markets are in a unique position right now. There's a lot of risk, especially in China and Brazil, as well as Greece, whose recent debt troubles have contributed to the downturn of the past few weeks.

Investors should expect some near-term pullbacks in this area, perhaps some quite significant ones. However, I don't think the near-term dangers outweigh the significant long-term potential of these areas. I still believe that emerging markets will offer some of the greatest growth opportunities over the next decade -- which means that investors shouldn't avoid these countries completely.

A reasoned approach
To protect yourself from further emerging markets downturns, consider allocating any new investment money to areas other than emerging markets this year. Think about shifting those new contributions to the domestic market, to a sector without an incredible run-up in the past year -- high-quality large-cap stocks. Think about stocking up on financially solid players like Wal-Mart and Johnson & Johnson (NYSE:JNJ) to capitalize on the gains of an up-and-coming market segment. I'm betting that this area of the market will outperform in the near future, while riskier stocks will be somewhat subdued.

But beyond that, you still need some skin in the emerging markets game -- just make sure you take a well-diversified, less-risky approach. You don't need to sell out of or reduce your emerging markets allocation right now, unless your portfolio allocation is out of whack because of the past year's run-up. If that's the case, by all means sell some emerging markets and rebalance to your target allocation.

When it comes to your specific emerging markets exposure, avoid single-country funds and ETFs. They're much too risky, especially now, when valuations are heightened. In this environment when risk is higher, you need broad coverage from a mutual fund or exchange-traded fund that invests across many emerging markets -- like Vanguard Emerging Markets Stock ETF (NYSE:VWO), which offers wide country exposure for a low 0.27% price tag. And remember that most broad-market actively managed international mutual funds have at least some emerging markets exposure, even if they typically focus on more developed economies, so you may have more exposure to this area than you realize.

Emerging markets are no doubt in for a roller-coaster ride in the near term as the global economy struggles to get back on its feet, so be prepared for some rough times. Don't underestimate the long-term power of developing economies -- but at the same time, don't underestimate their propensity for risk, especially now.