Some emerging markets are starting to look at a little pricey.
I have been increasingly edgy about the fate of emerging markets, and recent weeks have only made me more jumpy.
I first started worrying when financial advisors delivered their investment predictions for 2010, and went ga-ga over the prospects for the emerging gang of four, Brazil, Russia, India and China.
Financial advisers always need a story to sell -- sorry, tell -- to their clients, and when they all start telling the same story you know the plot is pretty much used up.
Scream if you want to go faster
The exhilarating pace of growth in the emerging regions has also made me dizzy. It is almost impossible to keep up this pace of expansion without overheating. Just look what happened to the dot.com and housing boom.
It is all moving too fast, particularly in China, and it seems the Chinese government agrees with me. Its move to curb lending and contain asset bubbles has spooked Western stock markets, which were getting uncomfortably dependent on the opiate of Chinese growth.
And now I have found somebody else who agrees with me (two in one day, that must be some kind of record).
Don't believe the hype
Rob Pemberton, investment director of wealth manager HFM Columbus, says the hype surrounding emerging markets could trip up investors who are anxious to get a slice of the action.
The hype is understandable, given that stock markets in China, India and Brazil grew 80% in 2009, while Russia delivered 100%, and all of them are rapidly gobbling up a bigger share of global GDP.
They have plenty of other factors in their favour, including low debt levels, young and dynamic populations, and a growing number of leading world companies. The fundamentals in these markets are predictable and positive, all of which should comfort investors.
But the comfortable investor is a complacent investor, and a complacent investor is likely to get stung.
Pigs and flies
Pemberton sees two unsightly flies in the ointment, volatility and valuations. Emerging markets may be more established than before, but they remain volatile. Even after last year's stunning rebound, prices in most in emerging markets are still well below where they stood at the beginning of 2008.
And despite all the fuss about decoupling, these markets remain closely correlated to the US. If Wall Street sneezes, the developing world gets swine flu.
Their economies may be decoupling from the US, but their stock markets still share the same handkerchief. Pemberton says this point is often overlooked by emerging market cheerleaders.
Read the big, bold print
Investors should look beyond economic and corporate profit growth, and focus instead on valuations.
Pemberton says value is disappearing: "Historically, emerging markets used to trade at a discount to developed markets due to their record of instability, but this is no longer the case and…" at this point he starts typing in bold italics and bigger print to make sure we get the point "emerging markets are starting to look dangerously pricey".
He examines the price/earnings ratio of the major developing markets, and discovers they're not cheap.
"China and Brazil trade on around 14x earnings, in line with developed markets, and India a pretty rich 18x. The only significant emerging market with a P/E of less than 10x is Russia.
"Advocates of emerging markets argue that a P/E premium is warranted because of the growth potential -- but our view is that political and corporate risk is still much higher than in the developed world.
"Were book values to rise above current level of 2x and P/E ratios hike up to around 18x then investors should assume they are in dreaded 'bubble' territory and be fearful of an imminent and painful correction."
Fall back to the future
Pemberton isn't forecasting the end of the emerging markets story, and neither am I. But he does foresee a major disruption.
Like me, he still backs them for the long haul, but suggests investors should wait for a correction before committing new money.
That correction may already be underway. My two favourite emerging markets investment trusts, BlackRock Latin American (LSE: BRLA) and Scottish Oriental Smaller Companies (LSE: SST), have pulled back sharply in the last few days.
I can see them pulling back further, but I'm not selling, because I'm sure they will rebound one day, and I don't want to miss that.
But I will be watching to see exactly how far they fall, and if we see a sizeable collection I will throw a bit more money in their direction.
Volatility and valuations are the two threats facing emerging markets. You can't do much volatility, apart from sit it out, but it would be foolish to squander an opportunity to buy at markedly lower valuations.
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Harvey owns shares in BlackRock Latin American and Scottish Oriental Smaller Companies.
