Stock Market Drop: Here’s Why the Emerging Markets Crisis of 2014 is a Red Herring

With U.S. and global stock markets continuing to slide this week, the long-awaited market correction may be upon us. With the Japanese market sliding 4% overnight, it now looks like the current pullback may have more to go.

As I wrote in January, the overwhelming optimism for U.S. markets at the start of the year had made me cautious. My favorite sentiment indicators were showing that the market was overbought. And in my mind, a pullback was always a matter of “when” rather than “if.”

That said, it is worth keeping some perspective. With the S&P 500 still only about 5% off its record high, the market has to fall quite a bit before its hits a 10% pullback -- the technical definition of a correction. If the current pullback feels bigger, that's simply because you haven't really seen one since May 2012.

Of course, Mr. Market's Moodswings always demand an exhaustive explanation by the media. And with the U.S. economy showing strength and Europe back from the precipice of collapse, today's doom-and-gloom crowd has shifted its attention to that old standby, emerging markets.

After a go-go decade and a half in the sun, it's as good a time as any for a reprise of the last big emerging markets crisis. The last big crisis was launched by the devaluation of the Thai Baht in July 1997, and culminated with the collapse of both the Russian stock market and the hedge fund Long Term Capital Management in August 1998.

In a meltdown I personally endured as a mutual fund manager of several emerging markets funds at the time, I remember President Bill Clinton describing that emerging markets meltdown as “the greatest financial crisis since the Great Depression.”

How wrong he was...

Why I Think it is a Good Time to Buy Emerging Markets

While I don't manage the billions in institutional money I did during the crisis of 1998, investors in my “Global Gains” Investment Program are feeling the heat in global stock markets as well.

Among the 44 global stock markets I monitor on a daily basis, only five are up for the year. And chances are you haven't been overweight on star performers like Vietnam and Egypt.

Nevertheless, I think emerging markets will do well this year.

Here's why...

1)Investors Hate Emerging Markets

I have written in the past about magazine covers as “My #1 Contrarian Indicator.”

Last week's Economist magazine had a negative cover about China.

This week's cover has a negative one about Putin's Russia.

And I bet you personally think the idea of investing in Russia is just nuts.

If so, you're not alone. Funds have flowed out of emerging markets for 14 consecutive weeks -- the longest streak since 2002. Emerging markets ETFs lost 4.8% of their assets just last week -- adding to the 10% they lost over the past three months.

Yet, if you believe -- as I do -- that the crowd gets in at almost exactly the wrong time, emerging markets are the asset class of the moment.

2)Emerging Markets Are Getting Crazy Cheap

The valuation gap between globaldeveloped markets and emerging markets is as high as I've ever seen since 1998. The MSCI Emerging Markets Index is trading at a forward price/earnings (P/E) ratio of 8.9 compared with 14.4 for developed markets. That's a discount of 38%. Put another way, emerging markets valuations are down by over a third compared with their 2007 peak.

Some of the company valuations are, frankly, absurdly cheap. Electronic giant Samsung, the world's #8 brand, is trading at a P/E ratio of 4.2. The much-hated Turkish banks are trading at book value even as they generate 15% return on equity.

Emerging markets bad boy Russia is trading at a P/E ratio of 5.4 -- despite bathing in the glory of the reflected light of the Sotchi Winter Olympic games. Russian natural gas giant Gazprom is trading at a P/E ratio of 3 -- the cheapest I remember seeing it since Western investors could first buy it in 1997.

If you follow the advice of “look down before you look up,” there just is not that much downside left in many emerging markets.

3)“Don't worry about the world ending tomorrow. It's already tomorrow in Australia.”

Investors are still suffering from post-2008 financial shock. Despite the facile comparisons, emerging markets are not in as bad a shape as they were in 1997. According to the Economist, only two emerging markets out of the 25 the magazine tracks have current account deficits of 5% gross domestic product (GDP) or more. And collectively, emerging markets boast foreign reserves of $7.7 trillion -- $3.7 trillion alone in China. Although investors are throwing out the baby with the bathwater, only a handful of economic ne'er do well's like Argentina, Turkey, Thailand and Indonesia should be suffering.

And even if emerging markets get hit, they do not (necessarily) take the rest of the world down with them. As market strategist Ed Yardeni points out, in 1997 -- the year the last emerging markets crisis started -- the U.S. market rose by 31%, with a correction of 9.6%. And despite the Russian meltdown in 1998, the S&P 500 gained 26.7%.

Emerging Markets: Danger Ahead?

That all said, it is tough to account for negative market sentiment -- or what emerging-market observers call “market contagion.”

Emerging markets can continue to go down simply because, well, they just do...

That said, it's precisely times like these that allow long-term investors to back up the truck and buy stocks cheaply.

My favorite recent story is from Warren Buffett. You may recall the U.S. credit rating was downgraded from “AAA” in August 2011. I spent a lot of time on the phone that month with my clients who were convinced we were on the verge of another 2008-style collapse. I was trying -- mostly unsuccessfully -- to talk them out of liquidating their positions.

Meanwhile, Buffett had his biggest day of the year as a buyer of U.S. stocks on August 8, 2011, literally the day the market bottomed.

Buffett was, of course, right. And, as I told my clients, I was buying heavily myself -- and have profited handsomely.

Now if I could just convince you to do the same....

In case you missed it, I encourage you to read my e-letter column posted last week on Eagle Daily Investor about how Big Macs tell you about currencies in 2014. I also invite you to comment in the space provided below my Eagle Daily Investor commentary.