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Want to see some real damage?
Forget about the drop in the U.S. stock market that took the Standard & Poor's 500 ($INX) down 5.5% from May 5 through May 22. Or the 7% pounding that the Nasdaq Composite ($COMPX, news, msgs) absorbed in the same period to turn that index negative for 2006.
In India, they had to suspend trading for an hour when the Bombay Stock Exchange index, the Sensex, fell by 10% during the first two hours of the May 22 trading day. Trading was also halted for the session in Russian equities after the main index on the Moscow exchange fell 11% late in the day. The Sensex, despite an end of the day rally, still fell 4.2% for the day and at the end of the day was down 22% over the last eight trading sessions. Russian equities are down 25% from their May 5 high.
If investors needed a crash course -- and an expensive one -- in the risks of so-called emerging equity markets, they've just received one. Because these stock markets are so small, or so illiquid -- even if they show a larger official market capitalization -- it doesn't take a huge flood of hot money to send them soaring. And it doesn't take huge withdrawals of foreign cash to send them slumping.
A passage from India
India's Mumbai stock market is one of the largest of the emerging equity markets, with a market capitalization of $800 billion. But it's still not especially liquid: Only 30 stocks account for half of the market's total capitalization and just three stocks make up nearly one-third of the Sensex index. In 2005, $11 billion in overseas money flowed into the market, much of it concentrated in this handful of stocks. The first four months of the year brought in an additional $4 billion in overseas money. Enough so that foreign investors owned 13% of the stock market's capitalization, according to the International Monetary Fund.As quickly as this money flowed into the Indian stock market, it has fled even faster over the last few days. According to the Financial Times, overseas investors sold $555 million in the four sessions ending on May 18.
I think that what we've witnessed in the sell-offs in emerging markets and in the plunge in gold, copper, silver, platinum and other commodities (and commodity stocks) is a global flight out of more leverage and more speculative investments. As I argued in my May 23 column, "How Japan sank the U.S. market," by tasking liquidity out of the global financial markets and by promising to raise Japanese interest rates later in 2006, the Bank of Japan has put in motion a global re-setting of investors' risk tolerance.
Speculators attracted by the momentum of the gold, copper, and silver, and by the spectacular run-up in emerging stock markets, wanted to get out before other speculators could liquidate their positions. With Japanese interest rates so low, and Japanese cash so abundant, speculators, traders, and investors have been more than willing in the last few years to take on risk at very low premiums. That game is ending.
But it isn't quite over. Risk tolerance doesn't get reset in a day. The Bank of Japan is only halfway through removing liquidity from its domestic and global markets. Interest rate hikes are likely to follow, with the first increases coming in the second half of 2006. Excess liquidity has by no means been removed from the global financial markets. And the correction that began in early May is just one step in the process of re-introducing investors to risk in these markets. I expect it will be followed by another speculative rally and another correction.
Buying the BRIC dips
None of this volatility, however, negates the fundamental story of behind the world's emerging markets. Countries such as Brazil, Russia, India, and China -- what Wall Street has termed the BRIC countries -- are indeed moving to take up important roles in the global economy. The process will produce greater wealth in those countries, expand middle classes and create new consumer markets. Investing in that process still makes sense to me.But the increase in volatility -- as the global financial markets reset the parameters for risk and return -- means that investors don't want to play this fundamental story by buying the riskiest emerging markets. The rewards in the riskiest markets are outweighed by the potential downside. I don't think this is a time, for example, to buy the opaque stocks of the Russian and Chinese markets, where outside investors have so little information on the internal operations of the companies. I don't think it's a time to be buying Turkish equities in the hope that the civil calm of the last three years will continue. Or to purchase the equities of Indonesia, betting that an expanding global economy will let all corrupt economies get by.
Instead I'd use this dip to buy quality in the emerging markets, to concentrate on the "B" and the "I" in the BRIC markets and buy shares in Brazil, the dominant economy of Latin America, and India, the best positioned of the emerging economies for the global knowledge economy of the 21st century.