Commentary: These Bourses May Be Too Darn Hot

Investors pondering a leap into emerging markets should proceed with caution

The Standard & Poor's 500-stock index is up 19.1% this year. Not bad. But that's chump change compared with the Bovespa, the index for the São Paulo exchange in Brazil. The gains there? A shade under 100%, when translated into dollars. If you want something a little more sedate, try the Bangkok set index. It's up a mere 89%.

Or how about something really exotic? Check out the Latvian RICI index. Up 140%. The Bloomberg terminal can't even tell you what stocks actually make up the Latvian index.

Emerging markets are hot, hot, hot. Hotels in Bombay and Bangalore are booked solid as investors fly in, looking for the next Infosys Technologies Ltd. (INFY ), the original India software star. Fund managers are poring over the books of Argentine steelmakers, Indonesian cigarette sellers, Polish juice peddlers. Their message: These equity and bond markets still have a long way to go. Not even the Oct. 27 plunge in Russian equities over the Yukos affair has dampened investors' ardor (Bangkok's index hit a six-year high the day after the Russian bourse melted). Stockpickers say they haven't seen such opportunities since the 1990s, when the world fell in love with Asia's tigers and even Argentina had a stable currency.

This euphoria sure feels like the 1990s. But it's hard to tell which part: the early '90s, when bourses from Hong Kong to Santiago began a multiyear run; or the decade's end, when emerging markets crashed, taking every starry-eyed investor with them.

When the rally will fizzle is anyone's guess, but it's time investors started asking tough questions. "There's a sense that emerging markets have come a long way and are due for a correction," says John R. Chisholm, executive vice-president of Boston-based Acadian Asset Management Inc., which handles about $1 billion in emerging- market assets.

There is, of course, a case to be made for this asset class. Mark Mobius, the veteran emerging-markets fund manager, points out in a recent report that these stocks and bonds were so bombed out in the past five years that they're still buys now, especially after solid gains in corporate governance. The spread between emerging-market bonds and U.S. Treasuries has been narrowing, a sign of improved confidence in developing economies. The average price-earnings ratio for emerging-market stocks is 13.6, compared with 21.9 for U.S. equities, so there's room to advance. Plus, currencies in these markets have strengthened, meaning returns in Hungarian forints or Brazilian reals get a boost when rendered in dollars.

But warning signals are starting to flash. For one thing, analysts expect U.S. interest rates to rise as the economy heats up, which could lure money away from emerging markets. "Statistically, the prices of bonds in emerging markets tend to be at least as sensitive to U.S. interest rates -- maybe even more sensitive -- than a lot of U.S. assets," notes Jeffrey A. Frankel, a currency expert at Harvard University's John F. Kennedy School of Government. "So when U.S. interest rates go up, it's not just U.S. bonds that fall."

Another red flag is the interest retail investors now have in emerging markets, a classic sign that they've passed their peak. "We are seeing more marginal investors holding indices up," says Stewart Paterson, chief Asian strategist at Credit Suisse First Boston in Hong Kong. Emerging-market funds have received $10 billion in net inflows this year, says, a Cambridge (Mass.) research firm, compared with net outflows of $99 million last year. And nasty surprises are accumulating. Chinese Internet stocks, for example, took a beating on Oct. 28, after the portal NetEase reported disappointing results. Inc.'s NASDAQ-traded stock had gone from $3.30 to $72 a share since October, 2002.

Don't forget currency risk: If the dollar tanks, says Mohamed El-Erian, a managing director at bond investor PIMCO, then global growth stalls, Asian central banks dump their U.S. Treasuries, and all bets are off. The party's still going on, of course. Just make sure you have an eye on the exit.

By Laura Cohn

With Jonathan Wheatley in São Paulo and Frederik Balfour and Bruce Einhorn in Hong Kong

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