Jim Jubak

The last few days — and in particular, Oct. 6 and Oct. 7 — have shown investors how markets are likely to work in at least the first half of 2012.

You need a little stock market history to flesh out the past few days and turn them into a road map for the next nine months or so, but I think the outlines are there.

I've written recently about the likelihood that sometime in 2012, the emerging stock markets of China, Brazil and the rest of the gang will decouple from the slow-growth developed economies and start growing independently. And they will drag the commodity economies of Australia, Canada and the rest of that global group along with them.

Around the middle of 2012 it will become clear enough to investors that China, to take the core case, isn't headed for a hard landing and that growth of 8.2 per cent to 8.5 per cent is indeed the likely bottom for this cycle. Global cash flows will move toward economies showing that kind of growth and out of developed stock markets where growth is stuck near one per cent to two per cent.

At that point, emerging stock markets will reverse the underperformance of November 2010 to now and begin to outperform their developed-country counterparts.

But what about the nine months or so (and maybe longer) until that certainty and outperformance arrive? What happens then?

This is where the action of the last few days and the lessons of stock-market history can suggest the likely details.

The pace of things
What we've seen in the bounce, or rally, or whatever, of the last few days from the stock markets of the developed and developing economies hasn't been a decoupling — Hong Kong's Hang Seng Index ($HSI) hasn't gone up while the U.S. Dow Jones Industrial Average ($INDU) has gone down — but rather a multiplication.

When the U.S. markets moved up on Thursday, emerging markets rocketed ahead even faster. When the U.S. markets pulled back a bit on Friday, emerging markets that were open when the U.S. markets were, such as Brazil's Bovespa, retreated even faster.

This is a classic emerging markets/developed markets pattern. Most of the time, when developed markets do well, emerging markets do even better. When developed markets do poorly, emerging markets do even worse. And emerging markets outperform and underperform with significant lead times; they tend not to lag the developed markets, waiting for them to get going, but, instead, precede them. They stage their initial rally while recovery still seems just a hope in developed markets.

(Much recent academic research has focused on whether, once you adjust for risk, emerging markets outperform enough in the good times to make up for this higher volatility. The conclusion reached by the papers I've read is that the risk-adjusted outperformance more than makes up for the additional downside risk. In other words, emerging markets can be very, very scary, but the emotional strain is worth it.)

So in 2008, China and the rest of the world's emerging markets began to outperform developed markets with the catalyst, I'd argue, of China's huge post-Lehman stimulus package. Developed markets wouldn't hit bottom until March 2009.

In 2010, emerging markets hit all-time highs in November. Developed markets wouldn't hit their peak until April 2011. From November 2010 through the beginning of the current bounce, emerging markets have lagged developed markets by 17 per cent, the Financial Times calculates.

A simple formula might be: When fear recedes enough for investors to take on more risk, stocks all around the world move up — and stocks in emerging markets move up fastest. When fear returns, as it did with Friday's downgrades of the government debt of Italy and Spain and of banks in the United Kingdom, stocks around the world fall — and stocks in emerging markets fall hardest.

What this tells me is that for the next nine months or so, emerging-market stocks will want to move up, recovering some of the ground lost since November 2010. But that they'll find it hard to make lasting progress if news from the United States and especially Europe keeps periodically scaring the devil out of investors.

All eyes on Europe
In my read, for example, if the leaders of the eurozone continue to look like (note I said "look like" — appearance is all, at least for a time) they're making progress toward finding a way to fund the operations of the Greek government, toward buttressing the capital of European banks and toward approving the expanded powers for the European Financial Stability Facility agreed to way back in July, then the global financial fear-o-meter will move lower.

Developed stock markets will continue to march ahead, and emerging markets will perform in overdrive as they work to make up their valuation discount to developed-market stocks.