Why Emerging Markets Fell Apart in 2011

For more than a decade, smart investors have looked to emerging markets to diversify their portfolios and tap into economies with huge growth rates. But despite ongoing economic uncertainty among the biggest parts of the developed global economy, including U.S., Europe, and Japan, emerging markets nevertheless saw very sharp losses in 2011.

That confirms a trend that I noticed late last year, when emerging markets largely failed to participate in the year-end rally that U.S. stocks enjoyed. But will current sentiment against emerging markets continue into 2012 as well? I'll get to that question a bit later in this article, but first, let's take a longer-term view of why investing in emerging markets has been so profitable for a long time.

What emerging markets gave you
Many investors have bemoaned the so-called "lost decade" for stocks. Looking back to the beginning of 2000, the S&P 500 is still far below its peak levels from the bull market of the 1990s. If you put money into an S&P 500 index fund 12 years ago, you've earned gains of less than 1% per year on average -- and that includes the dividends it paid you over that time frame.

But when you look at how stock markets in emerging countries have performed, it's an entirely different story. Broad emerging-market indexes have risen about 8% annually since late 1999, while some individual countries have done even better. Since its July 2000 inception, the iShares MSCI Brazil Index ETF (NYS: EWZ) has risen more than 12% per year -- and that lagged its benchmark by almost 2 percentage points!

What changed for emerging stocks?
Several factors have contributed to the huge success of emerging-market stocks. For one thing, given their strong status in their home markets, many emerging-market companies let investors tap into the enormous potential that their nations offer in general. For instance, Baidu (NAS: BIDU) has risen 17-fold since late 2005 because of its status as the dominant Internet portal in China -- a status that has survived challenges from U.S. Internet giants. SINA (NAS: SINA) has jumped even further, rising more than 3,700% since the end of 2001. And even after having fallen during the tech bust, China Mobile (NYS: CHL) has more than tripled in the past decade as telecoms went beyond landlines to the much faster growth opportunity in mobile communications.

Yet more recently, increasing numbers of companies have tried to take advantage of performance-chasing investors who are hungry for emerging-market exposure. Renren (NYS: RENN) and Youku.com (NYS: YOKU) have taken their places among established players Baidu and SINA, but collectively, the group has come under pressure on concerns that the Chinese government may make it harder for foreign investors to own shares.

At least for China, allegations of fraud that caused big losses for shareholders have injected fear throughout the stock market. After months without trading, several stocks still remain halted pending any resolution to the companies' business woes.

Moreover, the entire emerging world shares some problems. Rising food prices hurt India, Brazil, and China as well as other less-established emerging economies. For nations whose economies are booming, inflationary pressures have led interest rates higher -- yet Brazil has implemented attempts to limit foreign inflows of capital from currency and income traders seeking to take advantage of those higher rates in a way that might destabilize its domestic economy.

That in turn has led to fears that a slowdown in emerging markets could have a catastrophic effect on other economies, including those of developed countries. Already, companies like Petrobras (NYS: PBR) and Vale that provide natural resources that go in part toward infrastructure improvements and building activity in emerging markets have seen big pullbacks in their stocks. Moreover, a reversal of fortune in infrastructure wouldn't just hurt resource-rich countries like Brazil but would also hit developed players in mining, energy, and metal-making as well.

What to do
Last year, I suggested that while U.S. stocks were due to outperform emerging markets, you shouldn't dump all of your international exposure. By the same token, this year, I'll again argue that even if emerging markets are due for a bounce -- and I believe they are -- you shouldn't put your entire portfolio into them. It may not be exciting, but by allocating your investments across the full spectrum of available countries, you'll put yourself in the best long-term position to make money.

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At the time thisarticle was published Fool contributor Dan Caplinger wants to travel as much as his money does. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of China Mobile. Motley Fool newsletter services have recommended buying shares of Baidu, China Mobile, SINA, and Petrobras. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is good the whole world 'round.

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