Debunking Anti-Emerging Market Arguments

NEW YORK (TheStreet) -- There's been something of an anti-emerging markets investing theme developing in a couple places, each relying, in part, on research from Elroy Dimson, Paul Marsh and Mike Staunton from the London Business School five years ago.

Financial writer Jason Zweig noted that "there's essentially no correlation whatsoever between GDP growth and future stock-market returns." Still, Zweig didn't come to that conclusion from the Dimson, et al., research. I wrote a blog post that was critical of his conclusion, and Zweig, in turn, shared the report with me. Chris Sholto Heaton wrote an article that was also skeptical about emerging-market investing, citing the same report.

Dimson and his cohorts concluded that few countries have ever "graduated" to developing-market status; emerging markets have underperformed developed markets by 100 basis points annually since 1975; and, as Zweig said, there's little evidence of a correlation between gross domestic product growth and stock-market performance.

It doesn't make much sense to argue with the data -- it is what it is -- but I differ with the conclusions drawn by Zweig and Heaton. Since the report was published in November 2005, the iShares MSCI Emerging Markets Index Fund(EEM) has risen 61%, while the S&P 500 Index of large U.S. stocks has fallen 2%, and the iShares MSCI EAFE Index Fund(EFA) of developed countries is up 0.5%.

Producers of such research compile a lot of data, which is used by investors to make decisions. Unfortunately, historical data doesn't take into account what's happening today. Understanding how markets have worked in the past is useful but insufficient for making a forward-looking analysis.

There's no way to know how many people invest in emerging markets because they believe GDP growth predicts stock-market performance. As I said to Zweig in my email reply, investing in foreign countries is about seeking diversification. That means looking for countries that have different economic attributes than the U.S. and, as a result, different stock-market cycles, giving investors a chance to reduce volatility.

For example, stock markets in Norway, Chile and Brazil peaked in the second quarter of 2008 versus October 2007 for the U.S. That means as the U.S. was headed lower, those three moved higher for another six to eight months.