Crashing emerging markets could spell opportunity for smart investors

The sell-off in shares picked up speed on Friday.

The Dow Jones had a proper slide it was off by more than 300 points by the end of the session. As for emerging markets, they hit their lowest level in more than four months, as judged by the MSCI Emerging Markets index.

So is this a storm in a teacup? Or the start of something nasty?

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Emerging markets matter more than you might think

Secondly and perhaps more importantly the Federal Reserve is reining in the amount of money it prints. A lot of that money headed to emerging markets as investors got excited and began taking more risks. But as they start worrying about the taper', people are pulling money back to safe haven' assets like the dollar, the yen, and gold.

But does this emerging market sell-off really have much relevance for developed stock markets? Well, yes it does. The bearish argument is pretty straightforward. The stock market has risen on the back of multiple expansion'. That's City jargon, which simply means that the amount that investors are willing to pay for £1 of earnings has been rising.

Here's a simple example. Say you have a company that traded on a price/earnings (p/e) multiple of ten (ie you'd pay £10 for a pound of profit) three years ago. The share price has gone up by 50% since then. Sounds good.

However, if it's now trading on a multiple of 15, all that's happened is that profits have stayed the same. But now you are paying £15 for each £1 of earnings.

In short, the jump in the share price is not based on anything fundamental. It's either based on a growing sense of optimism that the company's earnings will recover rapidly in the future. Or more likely in this particular case it's based on the belief that central banks will keep pumping money into the market until recovery happens one way or the other.

Hence the problem: with the Fed reining in quantitative easing (QE), for markets to remain afloat, companies need to start justifying those rising p/e ratios.

But that might be tricky. For example, as Alison Smith notes in the FT this morning, in the last three months of 2013, more FTSE 350 companies issued profit warnings than at any time since 2008. As Keith McGregor at Ernst & Young notes, the recent spike in profit warnings was partly down to "a slowdown of emerging market growth coming through."

So emerging markets matter. I'd say that at least half of the fund managers I've spoken to over the past couple of years have used the emerging market consumer demand' narrative to justify their stock purchases.

Well, that consumer demand isn't going to be up to much if emerging market currencies crater. For a start, central banks may have to jack up interest rates to try to prevent currency crises (higher interest rates make a country more attractive to investors, assuming they're still confident they'll be able to get their money out at some point). But higher rates also mean tighter money for domestic consumers.

On top of that, a weaker currency means less buying power in the pocket of consumers. Not to mention lower profits for multinationals when those sales are converted back to stronger dollars.

So while an emerging market crisis may not lead to a repeat of 2008, it's certainly got the potential to cause a few nasty profit warnings in a market that's ill-prepared for them.

A good illustration of why we hold gold

cyclically-adjusted p/e (CAPE) ratio

But right now, the market is among the most overvalued in the world. That makes it more vulnerable than most developed markets to a knock-on impact from emerging markets. Particularly if economic data disappoints for any reason.

On the flipside, this is one of the many reasons I like Japan. Compared to its own history, Japan's current CAPE is low. With money-printing ongoing, and the economy genuinely picking up, I reckon there's more chance of profits surprising on the upside. Of course, if the US goes down, most markets will fall, and the Nikkei has slid along with the rest. But I feel more comfortable buying and holding Japan than I would the US at this point.

And it's worth remembering that this could all go away very quickly. The Fed might come to the rescue this week, and decide to hold off on tapering, for example. That would make it look spectacularly easily swayed, and could easily damage its credibility. But it wouldn't be the first time the Fed has promised to tighten then pulled a U-turn.

This is also a useful illustration of why you should hold gold in your portfolio as insurance. Amid the recent panic, it's one of the few things that's going up.

On that note, the companies that mine it have been performing even more spectacularly. To find out more about why this could be a good time to buy into the gold miners, have a look at this message from my colleague Simon Popple.

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