Emerging Markets and Dumb Money

Fund My Mutual Fund details (hat tip Abnormal Returns):

Stock markets of developing countries like India and Brazil have gone through the roof since early March, reversing some of their declines from last year. The MSCI Emerging Markets Index is up about 34% for the first six months of the year, after losing 54.5% in 2008. Some niche markets have had wilder swings. Russia’s benchmark RTS index is up 56% for the year’s first half, after losing 72.4% in 2008.

The chart below shows the three month rolling performance of the iShares MSCI Emerging Markets Index ETF (EEM). After last Fall's massive free fall, the ETF has performed exceptionally well.



But has it gone too far, too fast?

Fund My Mutual Fund thinks investors should beware. Along with the thought that current valuations may have rebounded ahead of fundamentals, there is another concern. Dumb money.

If you've been around these markets for a while you generally know by the time the retail investor is piling into a group, chasing huge scores - it's generally time to run away (at the least) and for the 5% among us who short, begin to think seriously about betting against the small fry. It sounds cold, but this is just the way it tends to work ... trust me, I used to be one of these people, so I learned the hard (read: expensive) way. As we read the piece below let us trust in the fact that none of these people were buying in early March, but most likely jumped in when it was "safe" a month or so later.

And jumped they have:

In the first five months of this year, investors poured a net $4.9 billion into diversified emerging-market mutual funds, more than reversing the net $2.6 billion they pulled out in all of 2008, according to Morningstar Inc.

There have been numerous studies on "dumb money". One such study by Andrea Frazzini and Owen Lamont Dumb money: Mutual fund flows and the cross-section of stock returns concludes:

That on average, retail investors direct their money to funds which invest in stocks that have low future returns. To achieve high returns, it is best to do the opposite of these investors.

So, the next time you hear from your neighbor about the next big thing, think twice. Or just bet against them...

Update:

Bloomberg ran a story this morning about the valuation of Emerging Market equities and while the analysis is different, the result is the same...

The last time stocks in developing countries got this expensive was in October 2007, just before the MSCI Emerging Markets Index began a 12-month tumble that erased half its value.

The MSCI gauge trades at 15.4 times reported earnings, compared with 14 for the Standard & Poor’s 500 Index, according to weekly data compiled by Bloomberg. When developing nations last commanded a premium, the 22-country benchmark sank 54 percent in the next year.