It sounded like a can't-miss proposition: Buy the winners, drop the losers.
Developing countries from Brazil to China are expanding much faster than aging economies in the U.S. and Europe, where borrowing during the boom years has been a drag on growth.
So the smart money bought stocks in emerging markets, expecting that rapid economic expansion there would provide better rewards. This year, that bet hasn't worked out.
The broadest measure of U.S. stocks, the Standard & Poor's 500 index, is down just 0.4 per cent this year. Markets in Brazil, China and the like have lagged far behind, even though their economies are still growing faster than the U.S.
"If you were anywhere in the world other than in the S&P 500 this year, you got crushed," said Greg Peterson, director of research at Ballentine Partners, an investment advisory firm.
The main reason emerging market stocks have suffered deeper losses isn't because their economies are suddenly sluggish.
Analysts say it's because people have been worried about the European debt crisis and a possible recession in the U.S.
It may seem unfair, but when fear of another financial crisis strikes money managers, they tend to flee emerging markets and stay closer to home.
This summer, panicked money managers dropped the most risky investments first. That meant bonds from deeply indebted countries like Italy and Portugal, small companies in the U.S and emerging market stocks got hit the hardest.
Even gold, an asset normally considered safe, dropped as traders shifted money into dollars.
"There was a globalization of fear," says Nathalie Wallace, a senior portfolio manager at Batterymarch Financial Management.
The same thing happened when the U.S. financial crisis hit in 2008. The S&P 500 fell 38.5 per cent for the year. But the MSCI Emerging Market index, made up of countries where the banks didn't peddle subprime mortgage bonds, plummeted 47.3 per cent.
"Anytime you see risk and fear coming, you see emerging markets get hit a bit more," Wallace says. "It doesn't mean the underlying fundamentals of the economy have changed."
Consider the collection of emerging-market rising stars known as the BRICs, which stands for Brazil, Russia, India and China. All have economies whose growth exceeds the U.S.
- Brazil: The economy has expanded 3.1 per cent over the past year. The benchmark Bovespa has lost 15.3 per cent.
- Russia: Economic growth of 5.1 per cent. The Micex has dropped 11.1 per cent this year, even after a 10 per cent rebound in the past month.
- India: Economic growth of 7.7 per cent. The BSE Sensex index is down 14.4 per cent.
- China: Economic growth of 9.1 per cent. The Shanghai Composite has slumped 10 per cent this year.
By contrast, the U.S. economy has expanded 1.6 per cent over the past 12 months. That's sluggish compared to the developing world's stars.
And worries that the U.S. could slip into a recession, or that Europe's debt crisis could tip it into one, have weighed on investors for months.
Even after those fears dragged down stocks nearly 20 per cent in a month, the S&P 500 outshines indexes in nearly all of the world's fastest growing economies.
In fact, if you rank the U.S. against emerging markets this year, it places ahead of 20 countries and behind just one, Indonesia.
China and other emerging markets long relied on shipping toys, timber and other goods to consumers in the U.S. and Europe. Trade helped them grow.
But that has a downside, says Tim Morris, a portfolio manager at J.P. Morgan's asset management unit. When a small country hitches its fortunes to U.S. shoppers, it's bound to suffer when the U.S. economy slows down.
A related problem for many emerging market countries is that they're dominated by energy and material producers, the type of companies most vulnerable to a global slowdown.
Todd Henry, an emerging markets equity specialist at T. Rowe Price, points to Brazil, a country that isn't as dependent on exports for growth.
"It's a relatively closed economy," Henry says. "But commodity and energy companies make up a large part of their stock market. So if the world is slowing down, that gets priced in."
The largest company in Brazil's stock index is the oil giant Petrobras. When the U.S. economy looks weak, the price of oil falls and the companies that sell oil fall, too.
That pushes down Petrobras, which tugs on the Bovespa. In other words, when the U.S. has the sniffles, Brazil's stock market still catches a cold.
"Americans tend to think our problems are limited to the U.S.," says Richard Bernstein, chief executive officer of Richard Bernstein Advisors LLC. "But our problems are their problems, too."
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