May's Market Collapse: What's an Investor to Do?
[EMAIL PROTECTED] | May 31, 2006
http://knowledge.wharton.upenn.edu/article/1492.cfm
American investors have poured money into foreign stocks in recent
years, lured by the hope of outsized gains. They have been well
rewarded in the past 12 months, but in May, markets plummeted around
the world.
Mutual funds investing in foreign stocks, for example, lost more
than 8% in the two weeks ended May 25, although their previous
stunning performance left them up nearly 31% for the 12 months
ending on that date. The late-May plunge was especially severe in
emerging markets, which rose nearly 50% in the 12 months ending in
early May but fell 13% in those late-May weeks. Latin American
funds, for example, dropped 10.7% in the week ending May 18, then
fell another 4.2% the next week. U.S. stocks have fallen too, with
the Standard & Poor's 500 down about 5% in the last three weeks of
May.
Is this another bubble bursting, the way the tech-stock bubble
collapsed several years ago?
Several Wharton professors argue that some emerging markets have
indeed been in a bubble, but that developed markets have not.
However, they do not expect the recent correction in emerging
markets stocks to turn into a deep, prolonged decline like the one
that settled in recent years on the tech-laden Nasdaq market in the
U.S. Despite recent experience, long-term investors, they say,
should embrace foreign stocks -- including those from emerging
markets -- while remembering that severe downturns come with the
territory.
Finance professor Jeremy Siegel believes emerging market stocks have
been in a bubble fueled in part by skyrocketing commodities prices,
since many emerging economies supply the world with metals, fuels
and other commodities. Also, trend-following investors have plowed
more and more money into emerging markets as they chased past
results, bidding stock prices ever higher. "I don't like markets
that just follow trends," he says. "They attract trend followers who
disregard fundamentals, and they all end this way eventually."
Foreign stocks in developed markets "were not in quite as much of a
bubble, but there are trend followers there, too," he adds.
Like many market watchers, Siegel says that worries about rising
interest rates triggered the May declines. Investors, he notes, had
expected the Federal Reserve to bring its two-year-old rate-hiking
cycle to a close sometime soon. But the Fed's statement after its
May 10 meeting suggested that growing inflation concerns might force
the Fed to keep raising rates. (Listen to Jeremy Siegel's podcast,
also in this issue of [EMAIL PROTECTED])
While many experts had expected hikes in the federal funds rate to
stop at the 5% level set May 10, there is now widespread concern it
could go to 6% or higher. "That really is a threat," Siegel
suggests. "When [Fed Chairman Ben] Bernanke did not signal a pause
at the last meeting, it resulted in a sort of disorientation." The
financial markets, he adds, "have kind of lost their moorings at
this point."
The Fed raises rates to discourage spending that leads to inflation.
Higher rates increase borrowing costs for consumers and businesses,
cutting into corporate sales. While that dampens inflation, cutting
sales also hurts profits, undermining stock prices. And as rates
rise, stocks have a harder time competing for investors' dollars
with bonds, bank savings and other fixed-income investments. When
demand for stocks shrinks, share prices fall.
Given the huge foreign stock gains of the past few years, many
investors expected a downturn and were more than eager to lock in
their gains by selling. Funds containing European stocks are up
nearly 28% over the past year, Pacific-region funds have gained
about 42% and Latin American funds nearly 62%. By comparison, funds
holding U.S. stocks were up a solid, but comparatively meager, 12%.
Overlooking the Risks
Wharton finance and economics professor Richard Marston notes that
big gains like those in emerging market stocks often arise from
excessive enthusiasm and overconfidence. Many investors excited by
emerging market gains of the past few years, he says, have
overlooked the risks in those markets, where small, inexperienced
economies are vulnerable to all sorts of shocks.
This overconfidence, he adds, is reflected in the spread, or
difference, between the interest rates on U.S. Treasury bonds and
bonds issued by emerging-market countries represented in the
Citigroup Global Emerging Market Sovereign Bond Index. Since 1996,
yield on the Citigroup index has averaged 600 basis points (6
percentage points) over the Treasury yield: If Treasuries yielded
4%, bonds in the index yielded 10%. The higher yields are a risk
premium that investors demand for taking the extra risk those bonds
entail -- that a country may default on its debts, for example.
Recently, however, that spread has narrowed to 200 basis points,
indicating bond investors are more sanguine about risks -- perhaps
too sanguine, Marston says. "It's basically telling you that the
bond market is so confident about the lack of crises ahead, that
they are willing to accept the lowest spread in premium since 1996.
That makes you nervous."
If something happens to undermine that confidence, the situation can
reverse very fast, he notes. During the Russian bond-default crisis
of 1998, spreads quickly broadened from 400 basis points to 1200
basis points, reflecting the higher risk seen in emerging-market
bonds. "Clearly, that would also spread to emerging-market stocks."
The recent pullback in emerging market stocks indicates investors'
confidence is declining, Marston adds. "In the case of emerging
markets, I think some of the markets just got so high that people
began to reassess and pull out."
According to Wharton management professor Gerald A. McDermott, stock
gains in emerging markets during the past few years had a solid
basis in factors like the run-up in commodities prices. "A lot of
that was driven by the basic fact that the world economy was
growing."
Investors with emerging market stocks can take some solace in the
fact that those stocks' recent declines "coincide completely with
the downturn in the past few weeks of the big markets," McDermott
notes. Stocks in the U.S., Europe and Asia have fallen in May. "Once
you see that, it's more about basic, big macro-economic cycles" than
it is about problems with specific emerging market countries. "I
think it probably was touched off by big geopolitical issues like
the price of oil, growth in the United States and inflation issues
in the United States."
That makes the decline less worrisome, he adds, as many emerging
market economies still appear quite healthy. "There's nothing I
see ... in Brazil, that accounts for a 3% [stock price] decline over
the past 10 days." Instead, he attributes the declines there and
elsewhere to "a general mood of uncertainty."
An Understandable Correction
Tremors in big markets can turn into earthquakes in smaller ones,
largely because so many investors now have worldwide holdings. When
stocks head downward in the U.S. and other big markets, investors
often react by pulling money out of the riskier positions in their
portfolios, such as emerging market holdings, Marston says. "You
will see the U.S. markets fall back, and then you will see the
emerging markets fall back even more, because people are reassessing
their entire portfolios."
Marshall E. Blume, professor of finance and financial management at
Wharton, agrees, noting that "the emerging markets are more risky."
When developed markets drop, emerging ones tend to drop even
further. In addition, with modern computers, communication and
investment products, international markets have become much more
integrated over the past decade or so. Now, he says, "what's bad for
the world economy is bad for the U.S., and what's bad for the U.S.
is bad for the rest of the world."
Rapidly growing economies, such as China's, have a heavy demand for
oil and other commodities, driving commodity prices up worldwide,
according to Blume. "Once you have rising commodity prices, you have
inflationary pressures. The central banks then start to squeeze the
economy by raising interest rates, and that has a negative impact on
growth. We are all tied together today.... Dampening of the economy
is not good for stocks."
Like his colleagues, Blume views the downturn in foreign stocks as
an understandable correction that does not signal the need for
investors to flee foreign stocks, or even emerging-market ones. "The
stock market could fall today and start to recover tomorrow," he
says.
He believes American investors should have 20-40% of their stock
holdings in foreign issues, including 4-5% in emerging market
issues. He says the only reason to sell foreign stocks now would be
to get back to the desired allocations, as the big gains of the past
few years have left many with more money in these stocks than they
intended.
Marston says that in a portfolio composed of 25% bonds and 75%
stocks, about 20% should be in foreign stocks, including 5% in
emerging markets.
According to Siegel, foreign stocks should take up as much as 40% of
one's stock portfolio, including about 8% for emerging markets --
figures he has not changed despite the recent downturn. Investors,
he insists, should not be making for the exits. "I think it's
beginning to be a good time to put money in [foreign stocks]." Will
the foreign and U.S stock markets turn upward again in 2006? "Yes,"
Siegel says. "I think markets are going to be heading higher by the
end of the year."
Published: May 31, 2006
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