Sometimes it takes investors a while to figure out that things have changed—and then it takes even longer for them to alter their behavior accordingly, writes MoneyShow editor-at-large Howard R. Gold, also of The Independent Agenda.

How many people bought technology stocks years after the Internet bust, hoping that Cisco Systems (CSCO) or JDS Uniphase (JDSU) would reclaim their former glory? They never did, of course.

The same thing is going on now with one of the few hot asset classes of the last decade: emerging market stocks.

Until the 2008-2009 crash, emerging markets were among the world’s top performers. These countries survived the Asian financial crisis and their economies boomed in the 2000s. China became a great economic power, Russia surged on higher oil prices, India was awakening from a long socialist sleep, and Brazil catapulted to the top of Latin America’s economic pecking order.

So, it would surprise many investors to learn that the much-maligned US stock market has outperformed the MSCI BRIC and emerging-markets indexes for the last three years.

In fact, US mutual fund investors pulled an astonishing $464.9 billion out of mutual funds focusing on US equities from 2007 to 2011, according to the Investment Company Institute. They stashed almost $800 billion into bond funds during that period, of course, but they also poured $73 billion into emerging-market equity funds.

Even in the first two months of 2012, US investors yanked $5.3 billion out of US equity funds and funneled $5.2 billion into emerging-market stock funds.

So, while US stocks were quietly recovering and outperforming, investors dumped them for an asset class that has lagged the entire time!

But individuals weren’t the only ones taking the sucker’s side of this bet. They have plenty of company among the so-called “smart money,” which more often than not behaves like the thundering herd.

John-Paul Smith, global emerging-market equity strategist at Deutsche Bank in London, told me he still has trouble persuading his US institutional clients not to invest in emerging markets, on which he’s been bearish for almost two years. (Scott is one of the few strategists in Wall Street and the City who knows how to pronounce and spell the word “sell.”)

“For the last 19 months I’ve preferred the US, and it’s been a huge outperformer,” he said in a phone interview, recalling that in 1999 he advised pension funds to sell US stocks and go heavier into emerging markets.

But, he continued, “we still see pent-up demand from US pension funds to increase allocation to emerging markets.”

Apparently pension fund consultants, looking in a rear-view mirror, have been recommending that institutions allocate more assets to emerging markets because of their past performance. And pension funds will follow them blindly, because nobody ever got fired for buying Petrobras (PBR), right?

Smith thinks pension funds are making a “huge misallocation of assets” that they will regret in two to three years. Because everything isn’t rosy for emerging markets, particularly the BRICs that stole all the headlines just a few years ago. The iShares MSCI BRIC Index (BKF) ETF trades below its 50- and 200-day moving averages, an ominous sign.

The biggest problem with emerging markets now, said Smith, is massive government involvement in the corporate sector, which he thinks is “much worse” than in developed markets. I hope some of you were sitting down when you read that.

“The influence of the state on returns for minority investors defines emerging equity markets,” he wrote in a report. “State influence will increasingly drive returns going forward as growth momentum fades.”

NEXT: Emerging Markets’ Dimmer Future

If you go through the leading emerging markets, Smith said, there’s no comparison with the relative laissez-faire approach of developed markets like Singapore, Hong Kong, and even the US.

And the prospects for these markets aren’t as glowing as they were just a few years ago.

The Chinese government, for example, has ratcheted down its growth projections to 7.5% to 8% a year. And its huge stimulus spending a few years ago has created massive debt at the local level, much of it going into redundant infrastructure and real estate speculation. Plus, wages are growing rapidly, squeezing profit margins.

And just as the government tries to reposition China from an export- and infrastructure-driven economy to one more dependent on consumption, the ruling Communist Party is going through an epic power struggle ahead of a once-in-a-decade leadership change.

That will likely mean less power for the big state-owned enterprises that dominate the major indexes tracking Chinese stocks.

I think China is in a long-term secular bear market, similar to what the Nikkei index has experienced for the last two decades. The Nikkei peaked above 40,000 and the Shanghai Composite index topped 6,000. Cows will graze on Jupiter before either hits those highs again.

Russia, a market I’ve never liked because of its volatility, also faces new challenges. The return of Vladimir Putin to the presidency, perhaps for another 12 years, raises the specter of authoritarian rule and crony capitalism or the kind of adventurism that led to the invasion of Georgia a few years ago.

Also, Russia’s bread and butter, energy, is threatened by a new competitor, the US. A shale-gas glut here has driven natural gas prices down to less than $2 per million BTUs, and efforts to export it are stepping up. Russia’s Gazprom charges $13 per mmBTU, and there’s only one direction that price can go.

Brazil was a magnificent stock market in the 2000s, but it’s struggled since. The Bovespa index is about 15% below its 2008 peak (the total US market is only 5.5% below its 2007 all-time high), as Brazil deals with a much stronger currency that’s stifling exports and slowing growth. The central bank has cut interest rates, but inflation remains a threat, and the slowdown in China won’t help.

“I’m bearish on Brazil…even though the valuations look OK,” said John-Paul Smith.

India also is having a much tougher time as rampant corruption and political paralysis have combined with huge deficits to dampen confidence in the country. High oil prices also are taking their toll on this massive energy importer. Standard & Poor’s cut its outlook on India’s credit rating Wednesday to negative from stable, threatening its investment-grade status.

US investors like emerging markets because they still believe that higher GDP growth means better stock market performance. But Elroy Dimson, Paul Marsh, and Mike Staunton of the London Business School did voluminous research on this and showed it was simply not true.

Yes, US politics and fiscal policies are toxic, Smith acknowledged. But it’s still not as bad here as in most of Europe or Japan—or even many emerging markets. “It’s an ugly contest and the US looks a lot less ugly,” he said.

Meanwhile, US companies are very well managed, have tons of cash, often pay dividends, and have large exposure to emerging markets with lower risk. What’s not to like?

US investors should have some exposure to emerging markets, but I don’t think it should be more than 5% of investable assets.

As Smith, nearly a 20-year veteran of emerging markets, told me: “If I didn’t have to invest in emerging markets at the moment, frankly I wouldn’t.”

When will US investors take the hint?

Howard R. Gold is editor at large for MoneyShow.com and a columnist for MarketWatch. You can follow him on Twitter @howardrgold or read his political blog, www.independentagenda.com.

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