In science, the butterfly effect is a metaphor from the chaos theory that goes something like this. If a butterfly flaps its wings in Asia, there is some kind of causal effect that triggers a tiny atmospheric change that could in theory lead to a hurricane in Chile. Similarly, in economics, such seemingly small changes in one part of the world could have an enormous impact somewhere else.
Case in point. Today, China released a report that showed its factories had increased production last month in response to a boost in new business. Based on that report, U.S. stock futures shot up after being lower for a good deal of the pre-market morning. Some dismal salary figures came in shortly thereafter and this brought them back down but they still remained in positive territory, mostly because of the Chinese manufacturing report.
The message for investors struggling to get their portfolios back in shape following the nearly two-year bear market is that we are in a global arena, whether you are invested in international securities such as emerging markets or not. What happens in China and India and in many other fast growing economies plays a major role in the sale of goods made in the U.S.
A few weeks ago, I wrote an article about the importance of investing in emerging markets as a way to improve your returns. And while I maintain that strategy, investors should remain cautious about how much of their portfolio should be invested in these more volatile markets.
In fact, there's research reported in the Wall Street Journal that shows you actually may do better by being partially invested in U.S. and emerging markets instead of just the developing countries even though the lure of huge returns beckons.
According to the Journal, if investors simply are increasing ownership of emerging-markets stocks from very low levels that's good. But some strategists warn that putting too much money into this market could cause an asset bubble and they point to recent data showing almost $50 billion flowed into emerging-markets equity funds this year through September, while $78 billion flowed out of developed-market funds.
That was based on data from fund-flow tracker EPFR Global. In the week ended October 6, emerging-markets equity funds attracted $6 billion, the largest weekly inflow in about three years.
One study by University of Florida finance professor Jay Ritter looked at market returns in 32 nations since the 1970s. It concluded that stock gains and economic performance can diverge dramatically. Speaking to the Journal, Dr. Ritter said, "a healthy economy isn't a guarantee that established companies will attract enough capital and labor to expand sales and earnings stronglyâ€”partly because they have to compete with newer ventures for resources."
Some investors have done very well investing in emerging-markets stocks. In fact, according to the Journal, anyone who invested in emerging-markets equities at the end of 2008, during the global financial crisis, could have realized a gain of around 75% in 2009 as global stock markets rebounded sharply from depressed levels. In contrast, the Standard & Poor's 500-stock index rose only 23% in 2009.
Still, an analysis by economists from Vanguard, the mutual fund giant, says that generally, over the past decade, emerging-markets investors were rewarded for the additional risk they were taking not because of high economic growth but because of comparatively low equity valuations.
The Vanguard analysts use the price/earnings ratio for the MSCI Emerging Markets Index on a trailing basis and it, according to the Journal, suggests that valuations for U.S. and emerging-markets stocks have moved much more closely into alignment recently.
To translate all this financial services speak, you should continue to own some emerging market stocks but if you are just now getting into the market, maybe you should wait or at least limit your exposure.
The Journal offers these tips:
1. Don't make an outsized wager on emerging markets. Emerging-markets stocks should represent around 10% to 15% of an investor's total equity portfolio, about in line with the proportionate share of emerging-markets stocks to total global stock-market capitalization, many investment pros say. Much more than that represents a move beyond diversification.
3. Instead, you might consider buying a broadly diversified emerging-markets fundâ€”or even an international-equity fund that includes emerging-markets shares. That way, you aren't tying performance to a single economy.
5. Consider getting some emerging-markets exposure via a large-cap U.S.-equities fund. By some estimates, the performance of more than half the companies in the S&P 500 depends more on global growth than on U.S. growth.