So much for “decoupling”…

The theory that emerging markets could decouple from U.S. financial turmoil has officially been culled. The index is now in the middle of its worst draw-down since 2002. A major part of the index including Korea, Russia, Taiwan, China, and Brazil is in a complete freefall.

Emerging markets have not escaped the global financial turmoil paralyzing stock and debt markets over the last 13 months. In 2008, the MSCI Emerging Markets Index has plunged 28%. That’s worse than the 20% decline logged by its sister index for the industrialized economies, the MSCI World Index.

Two key markets in the MSCI Emerging Markets Index have been pummeled over the last 60 days: South Korea and Russia. South Korea has dropped 13%, while Russia is down 10%. These two commodity giants are worth a combined 23% of the index, so they both have added to the sectors’ woes this year.

South Korea has won the booby prize for the worst performing currency in Asia this year. The country is down 19.4% versus the resurgent dollar. Last week the South Korean won sank to its lowest levels against the dollar in four years. The won sank despite government intervention to support the currency. Meanwhile, Korean shares have tanked 26% this year.

In Russia, global investors have dumped stocks in Moscow en masse over the last 30 days following its invasion of Georgia. The Moscow RTS Index, loaded with natural resource stocks, has crashed 36% in 2008. The ruble is also weakening against major currencies, despite Russia’s US$500 billion war chest of foreign-exchange reserves.

Other emerging markets are also declining sharply in 2008. Chinese stocks have crashed almost 60% this year followed by a 44% loss in India. The BRICs, or popular emerging market countries, that include Brazil, Russia, India and China, have collapsed 33% in 2008.

But do the emerging markets deserve this sort of valuation?

Emerging markets continue to sport far superior economic fundamentals than the major markets. Banks in the sector don’t have questionable balance sheets like those in the West. These banks have loads of free cash and will probably continue acquiring distressed American and European financial assets.

For the most part, emerging markets in Asia, including Russia, already went through a major economic crisis 10 years ago.

Boosted greatly by a bull market in raw materials since 2002, these countries are still home to almost US$3 trillion worth of reserves and high savings rates.

If oil and food prices continue to decline this fall, then you can make a strong case for buying this asset class again. Once inflation lowers and interest rates stabilize, we’ll see bullish developments in this region again. But before this can happen, U.S. asset markets must stabilize.