Foreign stocks are ready to rally

After months of underperformance compared with US equities, emerging-market stocks are moving higher on renewed dollar weakness.

By Anthony Mirhaydari Feb 18, 2011 8:35PM

One of the most popular investing themes of the past few years looks ready for a resurrection. I'm talking about foreign stocks, which attracted a lot of attention in 2009 and 2010 because of the exposure they offered to fast-growing economies like China and Brazil.

 

All that changed over the past six months as a new problem bubbled to the surface: inflation, driven by higher food and fuel prices. There are structural reasons foreign economies were more sensitive to rising prices. Alas, as the likes of China and Brazil tightened policy in response -- via interest-rate hikes, capital controls and tighter bank capital requirements -- investors fled out of fear of diminished economic growth. At the same time, the U.S. economy revved up.

 

As a result, since Oct. 1, the S&P 500 has climbed nearly 18%, while the iShares Emerging Markets (EEM) has added only 4.3%. Investors responded by pulling cash out of emerging-market mutual funds in a big way. Year to date, they've pulled a fifth of the record-setting $95 billion they put to work in EM during 2010, according to EPFR data. But now, for the first time since December, emerging-market stocks are perking up.

 

 

The catalyst appears to be a renewed slide in the U.S. dollar, which has violated its two-month uptrend today on growing concerns over the budget fight in Washington and the specter of a shutdown of the U.S. government. Also contributing are tough anti-inflation comments coming out of the European Central Bank, which seems to be taking nascent price pressures much more seriously than Fed chairman Ben Bernanke.

 

 

The folks over at Trade the News highlighted comments by ECB executive Lorenzo Bini Smaghi stressing the importance of taking "pre-emptive actions if needed" to prevent so-called "secondary effects" of inflation as food and fuel prices start pushing up prices of finished goods and services.

 

For their part, the inflation deniers at the Fed planted a piece in the Wall Street Journal today stressing how they aren't worried about inflation because the price of services remains low.

 

Before, they talked up how food and fuel inflation could be ignored because "core" inflation, which excluded these items, was trending downward. Now that January's Consumer Price Index data showed core prices moving higher on more expensive clothing and airline tickets, the Fed is just looking for a new justification for its $600 billion "QE2" money printing operation that is set to continue through June. It's like moving the goal post in the middle of a game.

 

All of this, combined with political gridlock in Washington, is pushing the dollar lower. And because of currency translation effects, this is forcing Wall Street traders to take a look at deeply discounted foreign equities. 

 

The renewed buying interest pushed the iShares Emerging Markets up and over its 20-day moving average as its On Balance Volume indicator suggests heavy accumulation is underway.

 

 

For those looking for more focused plays on individual countries, the Market Vectors Indonesia (IDX) is work a look after jumping 2.4% today. The Malaysia iShares (EWM), the Mexico iShares (EWW), and the iShares Thailand (THD) are all also worth a look.
For individual stock picks, PTTelekom Indonesia (TLK), Telefonos De Mexico (TMX), and Grupo Televisa (TV) all look attractive.

 

The last time foreign stocks assumed a market leadership role was last May in the wake of the May 6 "flash crash" event -- a trend that lasted six months. I believe a similar period of outperformance could be at hand as investors decide that the problems facing the United States are now more serious than those faced by developing economies.

 

Disclosure: Anthony does not own or control a position in any of the companies or funds mentioned. He has recommended IDX, EWM, and EWW to his newsletter subscribers.

 

Be sure to check out Anthony's new investment advisory service, The Edge. A two-week free trial has been extended to MSN Money readers. Click the link above to sign up.

 

The author can be contacted at anthony@edgeletter.com. Feel free to comment below.

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