Asian markets: 'Too much money, too fast'

(Money Magazine) -- With the news that China's economy grew a stunning 11.1 percent in the first quarter of this year, so did the odds that China's government will raise interest rates. That prospect shook markets in Asia Thursday, sending the Shanghai Composite Index down 4.5 percent, while Hong Kong's Hang Seng Index dropped 2.3 percent.

Such volatility is business as usual for Mark Headley, CEO of $9.5 billion Matthews International Capital, who first began investing in Asia in 1989. Currently, he manages or co-manages six of the nine Matthews Asian Funds, including the $3.2 billion Matthews Pacific Tiger (closed to new investors), $1.1 billion Matthews China and $464 million Matthews Asia Pacific.

"You have to have a long-term view in emerging markets," said Headley. "There's a lot of risk, but Asian countries are among the fastest-growing in the world."

That said, you should be cautious about jumping in now, following a year when Asian funds racked up 33 percent average returns and China funds specifically soared 62 percent. "Asian markets have had an amazing run. But a lot of that growth has been priced in, especially in China and India," said Headley. "There's been too much money coming in too fast."

Americans are fueling much of those cash inflows. In 2006 U.S. investors poured $192 billion into international funds, according to Financial Research Corp., which far exceeded the $43 billion invested in U.S stock funds. In the first two months of this year, foreign funds pulled in $46.5 billion, compared with $27.6 billion in domestic equity funds.

The headlong rush into international investing, especially Asian funds, worries Headley. "A lot of investors see the great performance but don't understand the risks," he says. "In recent years, they've been led to believe that any downturns are short-lived and that the markets just go back up to new highs."

In February, for example, China stocks had their single worst day in 10 years, with the Shanghai and Shenzhen indexes falling by more than 9 percent. But the markets quickly rebounded. The last sustained downturn in emerging markets took place in 1998, when funds plunged 30 percent or more.

The risks of a painful retrenchment are looming in China, where the red-hot economy has fueled massive building projects. "China is trying to slow growth, but clearly it hasn't been working," Headley observes. "The first-quarter numbers may push them to raise rates faster and restrict loan growth."

Meantime, Chinese stocks are trading at lofty valuations. "Chinese banks are trading at twice the value of HSBC (Charts)," Headley says. "Paying premium values is not what you should do at the top of bull market cycle." Still, the Matthews China fund is hanging on to its blue-chip holdings, which include China Mobile (Charts) and China Life Insurance (Charts).

Headley is also leery of India, where inflation has been running at a 6.5 percent rate. "Investors are paying 25 to 30 times earnings for better Indian companies," he notes. "At those valuations, you are vulnerable to sharp setbacks."

Even so, there are still bargains to found in Asia, Headley says, particularly in Japanese small-cap property companies. "Japanese real estate companies are coming out of a 14-year bear market," he remarks. "And we think there may be multiple years of appreciation ahead."

He's also adding more money to Korea, Thailand and Malaysia. "These countries may not be as exciting as India and China," Headley says. "But the valuations are reasonable. Thailand is lowering rates, while China and India are raising them."

Still, even the most undervalued Asian country is likely to deliver a roller-coaster ride. "When you invest in a region or single-country fund, you have to be awfully brave," says Headley. "You should ask yourself if you have the ability to watch your fund fall 30 percent and continue to invest."

For investors who lack that courage, Headley says, you are better off in a broadly diversified international stock fund.