Smart risks for cautious investors

By Jim Jubak

Put stocks from the world's emerging markets -- Brazil, South Africa, India and China, especially -- on your watch list. They're selling at fire-sale prices. And they're not just for daredevils anymore.

Even if you're a relatively conservative investor, you have to own a share of these markets once the bear has taken its claws out of stocks. That's especially true if you have any hope of rebuilding the wealth you've lost in this bear market.

The emerging stock markets and the developing economies of the world -- and not the developed markets and economies -- are where the action will be in the next decade.

Aren't these markets too risky? Fair question. They sure aren't your standard widows-and-orphans investments, and these markets haven't lost all of their historical and hysterical volatility. But relative to the stock markets of the developed world, the world's emerging stock markets have become less volatile and more rewarding.

I can make a case that these markets are far and away the risk-return leaders of all of the world's stock markets right now.

A tale of 2 indexes

Let me start with the sad story of the Standard & Poor's 500 Index ($INX) over the decade that is so fittingly nicknamed "the Oughts."

In 2000, the S&P 500, the traditional measure of big-company U.S. stocks, peaked at 1,527 on March 23. The bear market that ruled U.S. stocks from then until October 2002 took the index down to a low of 778 on Oct. 9, 2002. That's a huge 49% drop in the bear market of 2000-02.

The bear market that began in October 2007 had, as of this last Nov. 12, taken a comparable bite out of the index. The S&P 500 peaked at 1,565 on Oct. 9, 2007, and closed at 852 on Nov. 12. That's a drop of 46%.

• Talk back: Would you invest in emerging markets when conditions improve?

But what's really ominous if you're an investor in U.S. stocks is the utter stagnation in the S&P 500 since 2000. From peak to peak, the index gained 2.5% in roughly 7 1/2 years. (The total return for the period was slightly higher -- about 3.14% -- because of dividends.)

Roughly the same picture emerges trough to trough for the S&P 500, although we don't know where the current bear market will leave the index when it's over. The Nov. 12 closing price was only 9.5% ahead of the bottom in October 2002. And remember, this bear still hasn't put in a bottom.

No matter how you measure it, investors in the U.S.-based S&P 500 have gotten a lot of volatility in the Oughts -- 49% in the decade's first bear market and 46% and counting in the current bear -- and only meager gains of 2.5% peak to peak or 9.5% trough to trough.

Now compare this to the volatility and the returns for the world's emerging stock markets. I'm going to use the Morgan Stanley Capital International Emerging Markets Index to measure the performance of these markets.

The volatility is still huge. From the top in March 2000 at 499, the MSCI index fell to a low of 251 in September 2001. That's a drop of almost exactly 50%. From the next peak in October 2007 to the close at 533 on Nov. 12, the emerging markets index was down almost 60%. That's a significant 14 percentage points worse than the performance of the S&P 500 in the current peak-to-trough period.

But look what happens if you measure peak-to-peak or trough-to-trough gains and compare them with the gains of the S&P 500. Peak to peak -- that's March 31, 2000, to Oct. 30, 2007 -- the gain on the emerging markets index was 168%. Trough to trough (or at least the trough so far), the gain from the bottom on Sept. 28, 2001, to the Nov. 12 close was 112%.

Remember the comparable figures for the S&P 500: peak to peak, a 2.5% gain, and trough to trough, a 9.5% gain.

Big reward, relatively small risk

Even if you compare the 60% drop in the emerging markets index with the 46% drop in the S&P 500 in the current bear market and conclude that emerging markets are more volatile, you're still looking at a 14-percentage-point relative downside in volatility for emerging markets against a 165.5- or 102.5-point relative upside outperformance for the emerging markets index versus the S&P 500.

That's a huge reward to investors in emerging markets for a relatively small increase in risk.

It hasn't always been so. In 1998, the Russian stock, bond and currency markets collapsed. Inflation climbed to 84%. Banks closed. The ruble plunged in value.

Just a year before, starting in July 1997, the Asian currency crisis ravaged Thailand and then went on to pull down the stock markets and the economies of Indonesia, the Philippines, South Korea and Hong Kong. Growth dropped to zero in the Philippines in 1998. The Thai stock market fell 75%. Moody's downgraded Indonesia's bonds to junk.

The MSCI Emerging Markets Index fell 13% in 1997 and 28% in 1998. In contrast, the U.S. stock market experienced two of its best years then, with the S&P 500 climbing 30% in 1997 and 26% in 1998.

Continued: What has changed

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