Flying Too High?

Illustration for TIME by Wesley Bedrosian

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Market bubbles are not obvious when they are occurring. Even former U.S. Federal Reserve Chairman Alan Greenspan says he's unable to tell for sure when exuberance becomes irrational. While being questioned before Congress a couple of years ago about the 2000 tech-stock meltdown, Greenspan famously said: "As events evolved, we recognized that, despite our suspicions, it was very difficult to definitively identify a bubble until after the fact — that is, when its bursting confirmed its existence."

In other words, investors sometimes find themselves driving down treacherous roads with only their rearview mirrors to guide them. This is a particularly discomfiting thought right now, when the word bubble is being bandied about to describe emerging markets. Stock markets from Mumbai to Shanghai have been hitting record highs with giddy regularity recently, in spite of dangers such as the murky outlook for the U.S. economy. The CSI 300, a benchmark index for China stocks, has nearly quadrupled in the past year, while India's Sensex index is up 35% since January. Even Nigeria's stock market, a relative newcomer to the radar screen of global investors, has jumped almost 60% in 2007. (The value of stocks listed in Nigeria is now almost double that of shares listed in Argentina, even though Argentina's economy is far more developed and twice the size of Nigeria's.) Worldwide, the total value of shares from 25 countries tracked on the MSCI Emerging Market Index is now at its highest level since the mid-1990s, a time considered by many to have been a bubble (one that was popped by the 1997 Asian crisis and Russia's credit default). Yet investors are still piling in — inflows into emerging-market funds have been about $24 billion so far this year, exceeding $22.4 billion for all of last year.

Are latecomers bound to lose their shirts? Not necessarily. That's because, with some well-publicized exceptions, emerging markets are on the whole not in bubble territory. Yes, share prices have been rising rapidly. But so have corporate earnings during what has become an epic global economic boom. As a result, emerging-market stocks still look relatively cheap. Based on projected 12-month earnings, the average price-to-earnings (P/E) ratio of companies in emerging countries tracked by the MSCI index is 13. For the MSCI World Index, which includes developed countries, the average P/E is 14.

Bearish commentators argue that the disappearance of longstanding differences in valuations between emerging markets and the rest of the world indicates the former have risen too far, too fast. Historically, investors tended to buy shares of companies in emerging countries only when they could be purchased at hefty discounts to their counterparts in the West, because emerging markets were thought to be inherently riskier. And if nothing had changed since 1997, emerging-market stocks would indeed look expensive today.

But things have changed — greatly. Economies in countries such as Brazil and India have become more robust, more diversified and consequently less vulnerable to economic downturns in the U.S. and Europe. Many companies in developing countries are today better capitalized and better managed than they were 10 years ago, helping to justify valuations that are more on par with companies in developed countries. In fact, some emerging-market sectors look very cheap. Manufacturers of technology products, such as computers, are trading at an average discount of almost 20% to their industrial-country peers, even though they enjoy significantly higher earnings growth. No bubble there. Nor is there a bubble in South Korea, where the average P/E based on projected earnings is less than 12, nor is there in Turkey, where the average P/E is 10.6 — just to mention two countries where stocks are not overpriced.

This is not to suggest that all emerging markets are attractive. There are major gas pockets in China stocks, which are trading on mainland bourses at levels reminiscent of the heady days of the dotcom bubble. Hong Kong's stock exchange, where many China companies are listed, is experiencing similar exuberance, having risen more than 40% since mid-August. Soaring markets like these are getting a lot of press. But don't make the mistake of assuming all emerging markets are overvalued just like they were 10 years ago, right before the last bubble popped. That would be like driving using only your rearview mirror.