The Perils of Hot-Economy Investing

Is anyone still clueless about China and India? Probably not, but here are the numbers anyway: China's economy grew by 8.7% in 2009, accelerating to a 10.7% annual pace by year's end. India, the other country preordained to eat America's lunch, posted 2009 GDP growth of 5.6%.

That's even more impressive when you consider the aggregate world economy shrank by 0.8%, its first contraction since World War II.

Moreover, China and India are unlikely to fall back to the pack anytime soon. The International Monetary Fund expects the global economy to recover and grow by 3.9% in 2010, with China contributing its 10% annual GDP growth and India contributing its own 7.7%.

The picture is somewhat less expansive for the mature, established economies. The U.S. economy is expected to grow 2.7% this year; Germany's is expected grow to 1.5%; the United Kingdom's is expected to add 1.3%; and Japan's is expected to recover by 1.7%. Low expectations, to be sure.

A lot of people, a lot of potential
Given that China and India together account for 36% of the world's population, their popular trends have major implications. On that front, both countries continue to grow. According to CIA data, India's population, now 1.15 billion, is expanding at a 1.41% rate each year, while China's 1.34 billion inhabitants are adding 0.66% to the populace annually. The United States, with its 308 million inhabitants, is growing at at a 0.98% annual clip.

More importantly, the Chinese and the Indians are younger. The CIA tells us that 25 years is the median age for India, 34 for China, and 37 for the United States. The CIA also tells us that the percentage of the population aged 65 and over is also much lower in China and India.

Does that mean the smart money is migrating to these higher-populated, faster-growing regions? I don't know whether it's smart or not, but money is certainly moving.

China's foreign-exchange reserves, the world's largest, stood at a record $2.4 trillion at the end of 2009. The Reserve Bank of India has said India might have to control capital influx to avoid "economic imbalances," according to The Economic Times.

This torrent of capital has helped buoy both countries' major exchanges in 2009. This time last year, China's SSE Index was trading around 2,000; today it's around 3,000. India's BSE SENSEX was trading at 10,000; today it's topping 16,000. In less than 10 years, the BSE SENSEX has quintupled in price, while the SSE had spiked to nearly 6,000 in 2007. 

But that doesn't mean we're looking at the Internet-maddened U.S. market circa 1999. At least a few major stocks in both countries appear less than frothy, if not downright value-riffic:

Source: Google Finance.

Of course, these issues might appear less than frothy because they've completely fizzled. Since peaking in late 2007, the aforementioned stocks are either flat or losers.

Picking stocks -- growth or otherwise -- is never easy. For every China Mobile and InfoSystems, a superfluity of companies like KongZhong (NASDAQ:KONG) and Satyam Computer Services (NYSE:SAY) propagate. Therefore, many of us prefer to spread the wealth and the risk. iShares FTSE/Xinhua China 25 Index Fund (NYSE:FXI), SPDR S&P China ETF, Powershares India ETF, and iShares S&P India Nifty 50 Index are a few of the funds offering that opportunity.  

A lot of potential, but no done deal
That said, diversification isn't the end-all to risk reduction. It's fine for reducing unsystematic risk, but it fails to eliminate systematic risk, which looms more ominously -- and not only in matters of economy. 

Yes, China's 2009 $4.75 trillion GDP is the world's third-largest, but it's still dwarfed by the United States' $14.2 trillion. India's $1.24 trillion doesn't come close. Meanwhile, the United States far surpasses China and India in not-inconsequential matters of rule of law, property rights, and freedom. The Heritage Foundation's 2010 Index of Economic Freedom ranks China 140th and India 124th out of 179 countries. The United States ranks eighth.

In June 2006, MoneyWeek interviewed Jim Rogers, who proclaimed, "Asia is extremely exciting. It's like moving to London in 1805, or New York in 1905." Not really, Jim. London of 1805 and New York of 1905 were exemplars of lassiez-faire compared to India's regulatory-addled business market and China's autocratic economy of 2010.

One of my ironclad laws of economics goes something like this: The greater the regulatory and autocratic overhang, the greater the odds government will screw things up. There's a reason why emerging economies always seem to be emerging, yet are never emerged. It's nearly always political.