Big Bets on Emerging Markets Can Bomb

Financial adviser Dawn Bennett said in a Barron's article this week that she was getting out of U.S. stocks and putting everything in "emerging markets, gold and natural resources."

She says "policy and habits" -- government spending, Federal Reserve actions and consumer debt -- will be huge obstacles for stock markets in the U.S. and other developed nations. The voices of the "3.5 billion to 4 billion consumers" in emerging countries are beginning to be heard in the world economic order, she says. In other words, the middle class is expanding in these nations.

Bennett makes a compelling case that's been echoed elsewhere. She favors Peru, China, Brazil and India, in that order, because their economies are poised to grow as the U.S. outlook remains dismal. Based on the interview, it sounds like those countries account for more than half of her portfolio, with the rest invested in gold and other natural resources.

She doesn't say how she reaches this allocation, but there are stocks and exchange traded funds that can help investors follow this strategy. But investors shouldn't try her approach without considering the dangers of such concentrated bets.

The first chart compares the Shanghai Composite Index, India's BSE Sensex Index, Brazil's Bovespa Index and Compania de Minas Buenaventura ( BVN), the largest component in the iShares MSCI All Peru Capped Index ETF ( EPU ). In the middle of last year, the S&P 500 Index dropped 39% as these indexes lost more than 50%.

Bennett's favored markets in 2008
Source: Yahoo

The second chart below illustrates a bad month in 2006, the middle of the bull market. Around this time, emerging markets had a short violent spasm while the S&P 500 went down only 4.9%. Neither decline changed the long-term outlook for these countries, but panic selling ensued.

Bennett's favored markets in 2006
Source: Yahoo

Even if Bennett is correct, there will be declines, and any drops that affect emerging markets and commodities will crush the allocation she's targeting. The correlation between these asset classes has been high this decade.

As much as I agree with her (and I do), what if the thesis is simply incorrect? What if the dramatic increase in bank lending in China turns into a problem? What if the resources China has been supposedly hoarding turn out to be all its leaders need to deal with a crisis? What does that do to Brazil and Peru?

What if the world needs the U.S. to spur growth? Even China bulls concede the country isn't big enough to lift itself and the world into economic expansion.

Every investment thesis has the potential to be wrong, so making such a big push into emerging markets could prove disastrous if Bennett's predictions don't materialize. Her strategy seems to ride on one outcome. Perhaps Bennett has considered the potential for error in her analysis, but that wasn't conveyed in the article.

I always avoid making big bets in the portfolios I manage. Investors have a habit of jumping into the wrong thing at the wrong time, and the results are often ruinous. If you're not as good an analyst as Bennett is, you should consider a less aggressive approach.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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