American investors have poured money into foreign stocks in recent years, lured by the hope of outsized gains. They have been well rewarded in the past 12 months, but in May, markets plummeted around the world.

Mutual funds investing in foreign stocks, for example, lost more than 8% in the two weeks ended May 25, although their previous stunning performance left them up nearly 31% for the 12 months ending on that date. The late-May plunge was especially severe in emerging markets, which rose nearly 50% in the 12 months ending in early May but fell 13% in those late-May weeks. Latin American funds, for example, dropped 10.7% in the week ending May 18, then fell another 4.2% the next week. U.S. stocks have fallen too, with the Standard & Poor’s 500 down about 5% in the last three weeks of May.

Is this another bubble bursting, the way the tech-stock bubble collapsed several years ago?

Several Wharton professors argue that some emerging markets have indeed been in a bubble, but that developed markets have not. However, they do not expect the recent correction in emerging markets stocks to turn into a deep, prolonged decline like the one that settled in recent years on the tech-laden Nasdaq market in the U.S. Despite recent experience, long-term investors, they say, should embrace foreign stocks — including those from emerging markets — while remembering that severe downturns come with the territory.

Finance professor Jeremy Siegel believes emerging market stocks have been in a bubble fueled in part by skyrocketing commodities prices, since many emerging economies supply the world with metals, fuels and other commodities. Also, trend-following investors have plowed more and more money into emerging markets as they chased past results, bidding stock prices ever higher. “I don’t like markets that just follow trends,” he says. “They attract trend followers who disregard fundamentals, and they all end this way eventually.” Foreign stocks in developed markets “were not in quite as much of a bubble, but there are trend followers there, too,” he adds.

Like many market watchers, Siegel says that worries about rising interest rates triggered the May declines. Investors, he notes, had expected the Federal Reserve to bring its two-year-old rate-hiking cycle to a close sometime soon. But the Fed’s statement after its May 10 meeting suggested that growing inflation concerns might force the Fed to keep raising rates. (Listen to Jeremy Siegel’s podcast, also in this issue of Knowledge at Wharton.)

While many experts had expected hikes in the federal funds rate to stop at the 5% level set May 10, there is now widespread concern it could go to 6% or higher. “That really is a threat,” Siegel suggests. “When [Fed Chairman Ben] Bernanke did not signal a pause at the last meeting, it resulted in a sort of disorientation.” The financial markets, he adds, “have kind of lost their moorings at this point.”

The Fed raises rates to discourage spending that leads to inflation. Higher rates increase borrowing costs for consumers and businesses, cutting into corporate sales. While that dampens inflation, cutting sales also hurts profits, undermining stock prices. And as rates rise, stocks have a harder time competing for investors’ dollars with bonds, bank savings and other fixed-income investments. When demand for stocks shrinks, share prices fall.

Given the huge foreign stock gains of the past few years, many investors expected a downturn and were more than eager to lock in their gains by selling. Funds containing European stocks are up nearly 28% over the past year, Pacific-region funds have gained about 42% and Latin American funds nearly 62%. By comparison, funds holding U.S. stocks were up a solid, but comparatively meager, 12%.

Overlooking the Risks

Wharton finance and economics professor Richard Marston notes that big gains like those in emerging market stocks often arise from excessive enthusiasm and overconfidence. Many investors excited by emerging market gains of the past few years, he says, have overlooked the risks in those markets, where small, inexperienced economies are vulnerable to all sorts of shocks.

This overconfidence, he adds, is reflected in the spread, or difference, between the interest rates on U.S. Treasury bonds and bonds issued by emerging-market countries represented in the Citigroup Global Emerging Market Sovereign Bond Index. Since 1996, yield on the Citigroup index has averaged 600 basis points (6 percentage points) over the Treasury yield: If Treasuries yielded 4%, bonds in the index yielded 10%. The higher yields are a risk premium that investors demand for taking the extra risk those bonds entail — that a country may default on its debts, for example.

Recently, however, that spread has narrowed to 200 basis points, indicating bond investors are more sanguine about risks — perhaps too sanguine, Marston says. “It’s basically telling you that the bond market is so confident about the lack of crises ahead, that they are willing to accept the lowest spread in premium since 1996. That makes you nervous.”

If something happens to undermine that confidence, the situation can reverse very fast, he notes. During the Russian bond-default crisis of 1998, spreads quickly broadened from 400 basis points to 1200 basis points, reflecting the higher risk seen in emerging-market bonds. “Clearly, that would also spread to emerging-market stocks.” The recent pullback in emerging market stocks indicates investors’ confidence is declining, Marston adds. “In the case of emerging markets, I think some of the markets just got so high that people began to reassess and pull out.”

According to Wharton management professor Gerald A. McDermott, stock gains in emerging markets during the past few years had a solid basis in factors like the run-up in commodities prices. “A lot of that was driven by the basic fact that the world economy was growing.”

Investors with emerging market stocks can take some solace in the fact that those stocks’ recent declines “coincide completely with the downturn in the past few weeks of the big markets,” McDermott notes. Stocks in the U.S., Europe and Asia have fallen in May. “Once you see that, it’s more about basic, big macro-economic cycles” than it is about problems with specific emerging market countries. “I think it probably was touched off by big geopolitical issues like the price of oil, growth in the United States and inflation issues in the United States.”

That makes the decline less worrisome, he adds, as many emerging market economies still appear quite healthy. “There’s nothing I see … in Brazil, that accounts for a 3% [stock price] decline over the past 10 days.” Instead, he attributes the declines there and elsewhere to “a general mood of uncertainty.”

An Understandable Correction

Tremors in big markets can turn into earthquakes in smaller ones, largely because so many investors now have worldwide holdings. When stocks head downward in the U.S. and other big markets, investors often react by pulling money out of the riskier positions in their portfolios, such as emerging market holdings, Marston says. “You will see the U.S. markets fall back, and then you will see the emerging markets fall back even more, because people are reassessing their entire portfolios.”

Marshall E. Blume, professor of finance and financial management at Wharton, agrees, noting that “the emerging markets are more risky.” When developed markets drop, emerging ones tend to drop even further. In addition, with modern computers, communication and investment products, international markets have become much more integrated over the past decade or so. Now, he says, “what’s bad for the world economy is bad for the U.S., and what’s bad for the U.S. is bad for the rest of the world.”

Rapidly growing economies, such as China’s, have a heavy demand for oil and other commodities, driving commodity prices up worldwide, according to Blume. “Once you have rising commodity prices, you have inflationary pressures. The central banks then start to squeeze the economy by raising interest rates, and that has a negative impact on growth. We are all tied together today…. Dampening of the economy is not good for stocks.”

Like his colleagues, Blume views the downturn in foreign stocks as an understandable correction that does not signal the need for investors to flee foreign stocks, or even emerging-market ones. “The stock market could fall today and start to recover tomorrow,” he says.

He believes American investors should have 20-40% of their stock holdings in foreign issues, including 4-5% in emerging market issues. He says the only reason to sell foreign stocks now would be to get back to the desired allocations, as the big gains of the past few years have left many with more money in these stocks than they intended.

Marston says that in a portfolio composed of 25% bonds and 75% stocks, about 20% should be in foreign stocks, including 5% in emerging markets.

According to Siegel, foreign stocks should take up as much as 40% of one’s stock portfolio, including about 8% for emerging markets — figures he has not changed despite the recent downturn. Investors, he insists, should not be making for the exits. “I think it’s beginning to be a good time to put money in [foreign stocks].” Will the foreign and U.S stock markets turn upward again in 2006? “Yes,” Siegel says. “I think markets are going to be heading higher by the end of the year.”