The waves of panic and euphoria are rolling in bigger and faster these days. In the last issue we noted we’d likely need to see a 500 point one-day Dow drop on some big bank or other company failure to get fund investors to panic sell at enough of a clip to warrant us stepping up again and buying. Monday’s Dow drop of 777 certainly fits the bill and surely led to some big sales. 

Then the sun came up Tuesday and the growing fears of another Great Depression magically abated -- at least with investors if not consumers. Wall Street decided this was the buying opportunity of the decade and bid the Dow up near 500 points.

Apparently all that stands between us and Dow 5,000 or 15,000 is whether the Government, in its infinite financial wisdom, writes the single biggest check in history to fix all that ails banks. If only it were so easy.

Until the big move up Tuesday we were expecting to see the largest pullout from mutual funds since 2002, which was incidentally an excellent time to buy stocks. We’ll have to wait and see, but we expect we’re going to have to go below Dow 10,000 before start adding more risk to the Powerfund Portfolios.

Besides having more thrills and chills than a roller coaster built inside a haunted house, the market’s mostly downward spiral is getting us closer to moving back into some of the very same funds we got out of in recent years, namely the emerging markets, small-cap foreign, microcap and junk bonds. We miss the days of 100% plus returns for hot funds over just a few years. We’re still waiting for other fund investors to lose a little more money, although we’ve already seen a key feature we look for when going into deeply downtrodden areas: net losses by fund investors as a group.

As the inventors of the MAXreturn, we watch how much money investors have actually made in a category of funds. Opportunities usually lie where others have lost money. Emerging markets have recently tipped into the negative.

How is this possible? If you look at a giant emerging markets fund like T. Rowe Price Emerging Markets (PRMSX), you see a spectacular five-year average annualized return of 24.2% as of August 31, 2008. 

Due to this performance success and general excitement for alternative assets around the world, this fund was recently tipping the scales at over $5 billion in investor assets. Unfortunately for investors, this fund didn’t seem like such a good idea five years ago. Back in late 2003 this fund had just $300 million in assets. It took years of hot returns before the money really poured in. 

Right around the peak in emerging markets in late 2007 this fund had $4.8 billion in assets. Then the fall started. This of course didn’t stop investors; many probably thought it was a buying opportunity. By April 2008 it had $5.1 billion in assets. Then the bottom fell out. After Monday’s wipeout, emerging markets in general were down about 45% from the peak. Some BRIC countries (Brazil, Russia, India, China) – the recent focus of PRMSX – have been hit even harder.

Side note: When “emerging markets” is not exciting enough and the investing world starts inventing terms like BRIC, then it’s time to take a WALK. Remember B2B Internet funds? 

And it gets better – or worse. Since the BRIC countries were becoming too big and too “boring,” the whole investment community moved onto smaller game: The “emerging-emerging” markets or frontier countries.

As of Monday’s close the T. Rowe Price Emerging Markets fund was down – ready – 43.8% for the year. If investors simply didn’t sell you would expect this fund to have about $3 billion in assets because of this negative performance. But they are not holding on - they are buying more. At the end of August the fund was down about 26% and the assets were at $4.43 billion.

So while the fund made investors as a whole a few hundred million on the way up, it is managing to destroy perhaps $2 billion or more on the way down.

And frankly, it’s about time. While we were in emerging market funds in 2002 in our higher risk newsletter portfolios, we cashed out in 2006, missing at least another year of very good times. (It’s always the last year before the drop that is most exciting. Remember 1999 for tech?) With this year’s carnage we’re barely even lower than in 2006. Well, at least we made money in emerging markets, which is more than the average investor in PRMSX can now say.

The real buying opportunity for emerging market funds will be when these bottom-fishers give up and start liquidating -- locking in their losses for eternity -- and move on to something safe until things improve in the markets. After a few years of good returns they will jump onto the next hot area that gets a lot of attention in the press or on TV.

We’re not trying to oversimplify investing in higher-risk funds. When we get back in, we could be too early and might catch some downward movement. But in the end, if you buy when others are selling and sell when they are buying, you’ll likely make some money..

This T. Rowe fund will have under $1 billion when we are near the bottom. There may be some exciting pops along the way, but this is the fund’s destiny -- guaranteed. This pattern is why some solid growth funds still have losses on the books from the tech bubble.

We’ll get out of our speculative emerging-market shorts soon and then wait to get back into these foreign markets once the hot money has left the building. In the meantime we’re seeing some interesting opportunities in closed-end funds now trading at fat panic-driven discounts to portfolio value per share (Net Asset Value or NAV). We’re still more excited about U.S. stocks and higher-risk bonds. But we’ll be ready to dust off the passport again someday.

Stay tuned. It may be an endless summer.