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The widely expected growth of emerging markets could be already baked into the price, and investors will suffer if these markets fail to deliver.

With analysts lowering their growth estimations on the United States and European Union, emerging markets are again in investors’ crosshairs. As reported by a Barron’s blog post, favored opinions include that “economies in Asia have actually been shoring up their balance sheets", they have been “learning valuable lessons from the 1997-98 meltdown”, and “emerging markets stocks in the region are trading at less than 13 times earnings estimates for 2011.” More importantly, their average GDP growth is 6.3% and earnings growth is 13%, “well above the almost flat prospects for the U.S. and Europe”.

We believe stock prices are generally driven by two components: Fundamentals and growth. The best investments are often made on companies with solid fundamentals and bright growth potential. Since growth is well expected for emerging markets, we’d like to focus on their fundamentals.

We consult our ETF ranking system to quantify fundamentals. Key attributes of the ranking system is listed below. For a brief understanding of our ranking system please read “ETF Ranking: A New Fundamental Approach That Drives Short-Term Return".

  • The ranking system is based on fundamentals. Individual stocks are ranked by their valuation, financial condition and return on capital. We extended the ranking system to ETFs. The rank of an ETF is calculated to be the weighted average over the ranks of stocks in its portfolio.

  • It has predictive power. We observed that stocks with higher ranks had a strong tendency to outperform those with lower ranks over a period of one week. The data show that moving up 10 rank points translates to an extra annualized return of 1.7% in the past 10 years, it ranks range from 0 to 100. As a mater of fact, the S&P 500 Index returned an annualized 2.5% in the same period.

  • Growth is stripped off. As readers may have noticed, growth is not fabricated into the ranking system. Stocks whose rich valuation is propped up by their growth potential are not going to have rosy ranks.

We select a couple of ADR ETFs to represent emerging markets since ADRs’ fundamental data are readily accessible. Also, it’s easier to invest in ADRs as they save the hassle of currency conversion or opening foreign brokerage accounts. We also rank ADR ETFs of developed and frontier markets for comparison.

Developed Markets

BLDRS Developed Markets 100 ADR Index Fund (NASDAQ:ADRD)

45

BLDRS Europe 100 ADR Index Fund (NASDAQ:ADRU)

46

Claymore/BNY Mellon Equal Weighted Euro-Pacific Leaders (NYSE:EEN)

46

RevenueShares ADR Fund (NYSEARCA:RTR)

46

Emerging Markets

BLDRS Asia 50 ADR Index Fund (NASDAQ:ADRA)

41

BLDRS Emerging Markets 50 ADR Index Fund (NASDAQ:ADRE)

42

Claymore/BNY Mellon BRIC (NYSEARCA:EEB)

43

Frontier Markets

Claymore/BNY Mellon Frontier Markets (NYSEARCA:FRN)

40

Domestic Market

PowerShares QQQ Trust (NASDAQ:QQQ)

66

SPDR S&P 500 ETF (NYSEARCA:SPY)

50

The ranks show that the U.S. has the most solid fundamentals vs. the rest of the world. In terms of fundamentals, QQQ is a better choice than SPY, probably due to the thick pile of cash hoarded by high-tech companies. Interested readers can check here for details.

Developed markets have lower ranks than the U.S. does. Then come emerging markets. Frontier markets come last.

On average, the ranks of emerging markets are about 8 points lower than that of SPY, and 24 points lower than that of QQQ. With 10 points translated to 1.7% annualized return in the past 10 years, we expect QQQ to outperform emerging markets by an annualized 4.1% (24 / 10 * 1.7% = 4.1%). A 4.1% rate sounds like it's not a big deal. But the S&P 500 returned a mere 2.5% in the past 10 years, so 4.1% is much higher than the market return.

Remember that the ranking system doesn’t consider growth. The lower rank of emerging markets means that their fundamentals are less solid than that of the U.S. Therefore, emerging markets should fetch a lower valuation than the U.S. does if we leave growth out of the equation. But they are valued at around 13 times earnings, on a par with the U.S. It would be fair to conclude that the valuation of emerging markets is propped up by the expected growth.

I wouldn’t guess how much growth is already baked into the valuation. But I’d like to mention some concerns I have on emerging markets.

  1. Growth is forward looking and making creditable growth forecast is inherently difficult. For this reason I think that growth is more speculative. And my experience is that valuation propped up by growth is more likely to collapse when times are gloomy. Investors want to ask-- what if emerging markets fail to deliver.

  2. Globalization reduced the probability that a single country or region could grow without help from others. Taking China as an example, its top three trade partners are the EU, the U.S. and Japan. Together they account for 41% trade of China. I’d expect the debt crisis of the EU and the nil growth of the U.S. and Japan will drag down the growth of emerging markets.

  3. Emerging markets still depend on the developed world for high-tech tools and products. If they do grow, their growth will channel to the developed world as well. Investors wouldn’t lose too much growth by investing in the U.S. because the fundamentals of the U.S. are in better shape. SPY and QQQ appear to be safer, especially when uncertainly is looming.

  4. The global financial markets are effectively linked together. Positive or negative sentiments will spread across the world in a split second. As lately reported on Barron’s, the emerging bond markets were under pressure because their developed cousins were under pressure. In today’s world, there is really nowhere to hide when financial storms hit. If investors want to diversify by moving into emerging markets, they may want to think again.

  5. Last but not least, when the Fed is trying to print the U.S. out of any recession, key developing countries – China and peers – are hiking interest rates to curb inflations. Certainly this will dampen growth prospects. Consequently, China’s A Share is among the worst performers in the world.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: 5 Reasons Emerging Markets May Not Live Up To Expectations