News this week that China has finally overtaken arch rival Japan as the world’s second largest economy is surely cause for celebration for investors in emerging markets equities. This happened in the second quarter of this year as Japan’s nominal gross domestic product came in at $1.288 trillion, less than China’s $1.337 trillion. Since China grew +10.3% in the second quarter while Japan grew only 2%, this differential is likely to widen. Japan cannot possibly reaccelerate to match the Chinese growth rate due to an ailing banking system and decidedly negative demographics.

China is still a very much underdeveloped economy that has years of growth ahead of it and some day will overtake the U.S. in size. The annual Chinese GDP is well over $5 trillion, while the U.S. is a little over $14 trillion. The fundamental difference between the growth models in China and the U.S. is that the Chinese save and invest, while in the U.S. we depend on borrowing more and more money in order to consume.

I believe that the U.S. situation can be fixed with structural reform, but I don’t see the political will for that in the White House, or in Congress, or in the Federal Reserve — as that is a highly political institution too.

I hope they change their minds before it’s too late, as America is still the most successful market from a generational perspective. It’s not too late yet, but someone has to do it. I like to think of it as the difference between eating more cheesecake and buying running shoes — only one of those actions will help you get in shape.

Invest in the Secular Growth Stories

Because of this over-indebtedness, returns for the S&P 500 index — as measured by the Vanguard 500 Index Fund (VFINX) — have been a negative -1.3% a year for the past 10 years, but there are still $91 billion worth of assets in that fund. The investors in that fund are still waiting to make their promised 11% a year — and they’ll likely be waiting for a while.

I wrote the following in 2005, which was published in my book by Financial Times press in 2006:

The most common misconception about stocks is that their long-term average return is “guaranteed.” The average investor has been brainwashed into believing that one cannot lose money in the long term in the U.S. or any other stock market. The most widely advertised long-term annualized return for stocks is the 10.7% (usually quoted as 11%) derived from a study by Ibbotson Associates of stock market returns from 1926 to 2000.

Based on the belief that 11% describes a pretty good place to park your money for 20 or 30 years, the average investor is willing to wait out any financial storm. But in light of the collective experience since the top in the stock market in 2000, investors should question whether that 11% is a reliable performance indicator. If the market is flat for a decade or two (we have seen several such periods in U.S. stocks market history) any substantial deviation from the “11% return” assumption can be devastating.

$10,000 compounded at 11% over a 20 year period is $80,623; assuming a rate of return of 7% halves the end figure to $38,697, and at 3% the disappointment is just too much — $18,061.

Another fact that many commissioned financial professionals fail to share with their unsuspecting clients is that there have been long periods in U.S. financial history when stocks have produced no positive returns. The indexes can languish for many years in very wide, sideways trading ranges with big rallies and big selloffs that ultimately take them nowhere. There have been three periods in the last 100 years when the market has been flat for 15 or more years at a time. Those periods could sometimes comprise the whole investment horizon of an individual investor. If you happen to have invested near the beginning of one of those cycles, you pretty much got swindled by the phrase “stocks always go up in the long run.”

Driven by the “11%” rule, in the 1980s, and especially in the 1990s, public participation in the stock market dramatically increased. According to a recent study by the Investment Company Institute, assets held in mutual funds increased from under $300 billion in 1984 to $7.6 trillion by the end of June 2004. During the same time frame, the number of U.S. households owning mutual funds increased from 10.2 million (about 12%) to 53.9 million, or one out of every two U.S. households in 2004. That translates to 92.3 million individual fund shareholders.

The Wall Street selling machine has managed to quadruple the size of its mutual fund shareholder base in only two decades, while providing them with an inferior product. The product is inferior because most mutual fund managers have underperformed their benchmark indexes over those two decades, and due to the structure of the mutual fund industry are likely to do so in the future.

I saw this problem before most realized it and I tried to tell as many people as I could — and what is more important, I believe I found a solution.

The only way to escape the flat markets of the West is to invest in organically-growing emerging markets and the Western companies that are geared towards that emerging markets growth. Many such Western companies are in the S&P 500 index and make great investments on an individual basis.

I like most of the components of the Materials SPDR (NYSE: XLB) and the Energy Sector SPDR (NYSE: XLE) at the right prices that are driven by the more natural-resource intensive emerging markets economic growth; China is the world’s largest buyer of iron ore and copper and the second-biggest importer of crude oil.

I also like innovative companies that are not as much affected by this “spend and borrow” unsustainable growth model, like Apple (NASDAQ: AAPL), which overtook Microsoft (NASDAQ: MSFT) by market capitalization. I don’t own an Apple computer, but I admire their innovative spirit and the ability to come up with products that consumers want to buy. Another innovative company that should be bought on any correction is Netflix (NASDAQ: NFLX), which is reaching critical mass and still has room for growth.

There are many companies to buy in the S&P 500; it’s just not the whole index. If you’re looking for a broad market to invest in, however, look to China and other emerging markets.

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