Tim Middleton

Mutual Funds5/30/2006 12:00 AM ET

Time to leave the emerging-markets party

Investors are fleeing the group as the correction takes hold, and for good reason. Odds are the pullback will continue, so take your profits.

By Tim Middleton

One of the kids in Broadway's "The History Boys" dismisses history as "one *$^!% thing after another." That's certainly how it has played out in emerging markets.

Runaway inflation in Latin America; Russia reneging on another deal; Asian currencies in a twist; the latest Middle East crisis. And this month, air coming out of the bubble in commodities, which is the one asset most developing markets have in common.

After trebling in three years, prices of emerging-market stocks were due for a correction, and it was a doozie: A plunge of more than 16% in iShares MSCI Emerging Markets Index (EEM, news, msgs) between May 9 and May 24.

"The fever has broken in the commodity markets, in emerging stock markets and in currencies," says Ed Yardeni, chief investment strategist at Oak Associates. "This is a good thing. Risk aversion is back."

Bringing money back home

This is a good thing for U.S. markets, Yardeni argues, since they're less risky than developing bourses and will benefit as investors switch from there to here. But it's ominous for those risky emerging markets. They are very likely to fall further –- on average, 8.5% over the next 12 months, based on past emerging-market meltdowns.

Investors are already fleeing the group en masse. Inflows to emerging-markets mutual funds "have definitely dropped off, from $1.6 billion a week average in the year-to-date to just peanuts -- maybe $40 million," in the week ended May 17, says Brad Durham, managing director of EmergingPortfolio.com Fund Research. He estimates they turned into outflows after that.

I'm with those folks: The odds say now's a good time to take profits in this group. Don't even think about buying into it.

That sucking sound? Inflation

Commodities have taken a pummeling ultimately because the exuberant, demand-generating global economy is going to become less exuberant, which is demand-destroying.

Inflation is running ahead of the average it set over the last decade, and not just in the United States. To fight it, central banks have indicated they will continue raising interest rates (in the U.S.) or begin to (in Europe and Japan). Higher rates put a brake on business growth by pushing up costs.

Until now, Japan's near-zero interest rates have made possible the famous "carry trade," in which investors such as hedge funds borrow for practically nothing and use the money to invest in high-return assets like emerging markets. Higher rates put an end to that, and just the threat of them has throttled that market.

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