How to stop worrying and love emerging markets:James Saft

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

LONDON (Reuters) - Emerging markets are very likely the next bubble, but don't let that stop you.

Emerging market shares are already expensive relative to developed market ones, but economic growth in places like China and India will continue to pull away, and investors will pay an increasing premium for that, especially if the ageing economic giants of the 20th century slip from their long term growth paths.

And in a process we've seen before with internet stocks and houses, big returns will attract big money, driving further rises and making it all seem very sensible, at least for a while.

The definition of "a while" is of course, as with all bubbles, the key question.

Amazingly, the case for emerging markets being both a bubble and a good investment is being made by legendary value investor Jeremy Grantham.

"This bubble, like all bubbles, will not be justified by long-term value but at least will be one of the least flaky bubble cases ever," Grantham, chairman of fund manager GMO, wrote in a note to clients.

"Perhaps once in a career any self respecting strategist, even a one trick "mean reversion" one like GMO, should have a go at predicting a major divergence, a true bubble. And this is ours."

He points out that U.S. gross domestic product has in recent years been growing at below its long term 3.5 percent rate in real terms, despite a very supportive global environment and huge amounts of cheap financing.

At the same time, growth in emerging markets is higher, and is supported by boom prices for commodities and by a seemingly unstoppable movement of people into cities, driving both consumption and higher productivity.

Grantham's thesis, essentially, is that these diverging trends will continue, that everyone will realize it and that they will pile into emerging markets, thus inflating the bubble.

How big a bubble? The Japanese bubble peaked at a price to earnings ratios two to three times that of the rest of the world's stocks, while the NASDAQ one reached similar figures, according to GMO. Grantham argues that emerging markets could achieve a premium of 50 percent, which would be "far less than normal," but still a heck of a lot higher than current levels.

DECOUPLED, WEAKLY COUPLED OR TIED AT THE NECK?

Emerging market shares are now more expensive on a reported earnings basis than developed market stocks, a historically unusual situation.

Emerging shares are now selling at 15.9 times their reported earnings, as against just 14 times for developed markets. The median over the past 13 years is 15.6 for emerging and 22 times for developed, according to data from Societe Generale.