Emerging Markets

On several valuation measures, emerging markets have moved to premium valuations relative to large-cap developed markets (including U.S) stocks. Despite huge price gains in emerging markets over the past five years (35% annualized!), investors should maintain long-term commitments to the asset class.

Moreover, should another leg down develop in global stock markets, emerging markets may be the most attractive asset class to add exposure. Emerging markets will be the primary driver of global growth over the next several years; it stands to reason that their stock markets will continue to outperform, albeit with the usual volatility. Eventually, it seems reasonable to expect emerging markets to trade at substantial and consistent premium valuations to developed markets.

Emerging markets which have sufficient domestic demand will provide excellent diversification to investors since these markets will be less tied to the markets within the developed world. One measure used to analyze the linkage is the Trade-to-GDP ratio. For example, in 2005, India had a T-t-G ratio of only 37 indicating a lower correlation with USA and Western Europe than did the markets in Singapore and Malaysia with ratios of 432 and 218, respectively.

Emerging markets with a low correlation to those of the developed world will provide better diversification to investors, e.g., India, Brazil and South Africa.