Oct. 29 (Bloomberg) -- The global stock market rally, which resembles the bull run between 2003 and 2007, will end as government spending slows after so-called easy money boosted asset prices, according to Morgan Stanley.

“Such echo rallies are never as big as the original one and we will see it fading away,” Ruchir Sharma, 35, who oversees $25 billion in emerging-market stocks at Morgan Stanley, said in an interview in Mumbai. “The rally will end as the effects of the stimulus begin to fade and the credit bubble caused by easy money disappears.”

The MSCI Emerging Market Index, which tracks shares in developing markets, has surged 59 percent this year, set for its biggest annual advance since 1993, as governments poured in $2 trillion and central banks cut interest rates to near zero to kick-start their economies. Last year, the measure dropped 54 percent, its worst run in the gauge’s 20-year history.

A new rally globally needs to be driven by new industry groups, he added, while the current advance is led by the same sectors, such as commodities, as the ones in the bull market that ended in 2007. That’s not a good sign, he said.

The emerging-market index fell 1.3 percent to 904.64 as of 5:10 p.m. in Mumbai, a four-week low, after the Standard & Poor’s 500 Index lost 2 percent to 1,042.63 yesterday, the steepest drop since Oct. 1. Sharma, the New York-based head of emerging markets, said he expects the S&P 500 to trade in a “long-term” range of 800 to 1,200 in the next couple of years.

Pessimistic Outlook

Markets globally dropped last year following the biggest financial crisis since the 1930s as the bankruptcy of Lehman Brothers Holdings Inc. and writedowns from subprime debt caused a seizure in lending.

Only 31 percent of respondents to a poll of investors and analysts who are Bloomberg subscribers in the U.S., Europe and Asia see investment opportunities, down from 35 percent in the previous survey in July. Almost 40 percent in the latest quarterly survey, the Bloomberg Global Poll, say they are still hunkering down. U.S. investors are even more cautious, with more than 50 percent saying they are in a defensive crouch.

“The doubt and the pessimism just won’t go away,” said James Paulsen, who helps oversee $375 billion as chief investment strategist at Wells Capital Management in Minneapolis. “They’re still so shell-shocked by what they went through despite the improvement in the market and the economy.”

Earlier Forecast

Sharma predicted in May 2006 that emerging markets will post further gains. The index for developing nations has risen 20 percent since then, compared with a 16 percent drop in the MSCI World Index.

The commodity-producing nations will be the hardest hit when the current rally ends, Sharma said. The Latin American markets of Brazil and Chile are the most expensive, he said, and Morgan Stanley is also “underweight” on Taiwan, Malaysia, Israel and Russia. Commodity prices are rising even as economic fundamentals are deteriorating, he added, a sign that the rally may be fizzling.

“Commodities are at the centre of this echo bubble,” he said, adding that they are “in substantially overvalued territory, way above fundamentals.”

Inventories of oil, copper, aluminum have risen over the past few months even though demand hasn’t picked up, Sharma said, adding that the price of oil is inversely correlated to the U.S. dollar. Increasing buying of commodities as a hedge against the decline in the U.S. dollar has resulted in the commodity rally, he said.

‘Irrationality’

“The greatest degree of irrationality is in commodities,” Sharma said. Morgan Stanley owns a lower percentage of commodity stocks, including metals, materials, energy and industrials, compared with the benchmark index. It holds a higher percentage of financial and consumer stocks including automobiles, retailers and beer companies.

Some brokerages are predicting further gains in equities. The emerging markets benchmark stock index may retest its “life high” by next year, helped by economic growth and gains in credit markets, according to JPMorgan Chase & Co.

The optimism is shared by Mark Mobius, who oversees about $25 billion as executive chairman of Templeton Asset Management Ltd. The investor said this month he expects developing nations’ shares to surpass previous records, predicting a continued rally with “corrections along the way.”

Emerging Markets

Emerging markets make up all 10 of the world’s best- performing markets, according to data compiled by Bloomberg. Russia’s dollar-denominated RTS Index has been the world’s best- performer this year after climbing 112 percent.

Morgan Stanley is “overweight” on India, Indonesia, Poland, the Czech Republic, Turkey and Thailand, as it’s betting on economies that are driven by domestic demand. India, Indonesia and the Czech Republic are among the few countries that will end the year with earnings per share growth at all time highs, while countries like Russia and Taiwan will see corporate profits climbing back to their peaks in 2012, Sharma said.

Some markets may be hurt by the diversion of government stimulus away from the economy and into stocks and other investments. Central banks globally were hoping the funds would result in an increase in credit growth, driving the economy. That remains weak in most countries, Sharma said.

“Liquidity has found its way to the wrong assets,” he said. “You can take a horse to the water but can’t force it to drink.”

To contact the reporters on this story: Pooja Thakur in Mumbai at pthakur@bloomberg.net.

Last Updated: October 29, 2009 07:57 EDT