Emerging Markets' Dirty Little Secret

For many years, the argument for investing in foreign and emerging markets was the benefit of diversification. The thought was that, even if the U.S. economy was weak, stocks in South Korea…or Israel or Turkey could reap profits due to factors unique to their local regions.

That perceived diversification has been one of the prime motivations prompting an investor stampede. As we pointed out a few weeks back, money is cascading into emerging market stocks via easily tradable products like iShares MSCI Emerging Markets Index (EEM) and Claymore/BNY Mellon BRIC (EEB).

The performance of emerging markets since March has been nothing less than historic. But investors shouldn’t kid themselves into believing they’re diversifying their domestic portfolios by adding emerging markets, a thesis largely constructed back in the 1980s and 1990s before information technology made buying stocks in Brazil just as easy as buying Bank of America (BAC).

Correlation of Returns Against MSCI World Index

Source: Bloomberg, Rosewood Research

In today’s market, the diversification once afforded by emerging markets has almost disappeared altogether, meaning emerging markets move similarly to domestic and developed markets, only more so. The three-month rolling correlation between emerging market stocks and the MSCI World Stock Index, once as low as 10% back in 1999, now hovers near 80%, a relationship exhibited both during 2008 and the first quarter of 2009. When stocks fell, emerging market stocks fell even more – and still do to this day.

A similar re-transformation was seen in publicly traded real estate, which, as we pointed out earlier this year, became much more closely correlated with U.S. stocks over the course of the 2000s housing boom. By early 2009, the asset once purchased to diversify away from U.S. stocks was moving in near lockstep with them.

Emerging-markets stocks continue to soar, and while there are no tops in a bull market, investors should note that the supposed diversification provided by adding such far-flung locales to their portfolios petered out at least two years back. When stocks do crack…look for emerging markets to crumble.