Emerging Markets: Frothy or More Upside Left? (ETFs: EEM,

by: Abnormal Returns

Is sentiment towards the emerging markets getting frothy? There is no doubt that emerging markets have been red hot, with returns over the past year double that of the domestic market.

A piece by Ron Dugan at the newly revamped Institutional Investor site asks, "Do Emerging Markets Have Any Fuel Left in the Tank?" This is a contrarian take on the data which is nearly all positive:

Managers point out that fundamental indicators are positive. Earnings in the emerging countries have grown in double digits, averaging 25 percent in 2004 and 10.5 percent last year. Return-on-equity has almost doubled from 11 percent to 19 percent since 1999. Dramatic improvements have been shown in the health of corporate balance sheets, achieved through earnings growth and debt reduction. An enhanced regulatory environment, improved corporate governance and greater liquidity have started to occur in many of the emerging countries.

Caution therefore comes in two flavors. The first is that some sort of geopolitical event will cause an increase in caution towards these markets. The second is simply that the emerging markes have become over-owned and too popular. While many analysts have long touted emerging market equities as a portfolio diversifier, the recent run-up may include momentum investors who are apt to push prices above justified levels.

Tom Lauricella and Diya Gullapalli at the Wall Street Journal report that U.S. mutual fund investors are "shoveling" cash into emerging market equity funds. The risk to investors is that they are committing cash at the peak:

Fund managers are starting to warn investors that they are joining the party well after it started. "The highest level of assets comes in when a market is near its peak," says Kirk Henry, manager of Dreyfus Premier Emerging Markets Fund. Emerging markets historically have had big swings in prices, making an ill-timed investment an especially costly proposition.

This flood of cash has also created a dilemma for portfolio managers who are having problems finding attractive opportunities.

There's "now more money than opportunities out there," says Cameron Brandt, an analyst with EmergingPortfolio.com. Fund managers are "putting money into stocks that, in more usual times, they'd take a pass on."

The underlying fundamentals in the emerging markets are probably now better than have been in the past. However the strong returns have attracted an inordinate amount of attention. What had been a "portfolio diversifier" for many has become a bit of go-go arena. The only question is what event(s) prompt investors to pull back?

ETFs for Emerging Markets -- click on ticker for more opinion/analysis:

iShares MSCI Emerging Markets Indx (AMEX:EEM)
BLDRS Emerging Markets 50 ADR Index (NASDAQ:ADRE)
iShares MSCI Singapore Index Fund (NYSE:EWS)
iShares MSCI Taiwan Index (NYSE:EWT)
iShares MSCI Mexico Index (NYSE: EWW)
iShares MSCI Brazil Index (NYSE: EWZ)
iShares MSCI South Africa Index (AMEX: EZA)