Global pain


While it may seem hard to believe, the U.S. stock market has actually been among the world’s stronger performers this year. Through Oct. 28, the S&P 500 Index has fallen 35.9% for the year, versus a 50.7% decline in the bellwether MSCI EAFE (Europe, Australasia, Far East) Index and some startling drops in individual markets:

• United Kingdom (FTSE 100): -39.2%.
• Russia (DJ Russia Titans 10): -69.4%.
• Brazil (Sao Paulo Bovespa): -47.7%.
• China (Dow Jones CBN China 600): -67.3%.
• Netherlands (AEX): -53.9%.
• India (Bombay Sensex): -55.6%.
• Japan (Nikkei): -50.2%.

In fact, none of the major foreign markets tracked by Dow Jones has a gain in 2008.

Foreign markets must deal with many of the same factors hurting U.S. stocks — fears of bank failures, recession worries, frozen credit markets, and a lack of investor confidence — along with a few additional troubles:

Strengthening dollar. U.S. investors in foreign stock markets have enjoyed a tremendous tailwind in recent years because of the weakening dollar. Now that the dollar has strengthened — so far this year, the dollar is up 15% versus the Euro, 25% versus the British pound, 21% versus the Brazilian real, and 29% versus the Canadian dollar — currency has become a headwind.

Plunging commodity prices. Many foreign economies, especially those in emerging countries, are closely tied to natural resources. Dips in the price of commodities, most notably oil, have been especially punitive for such nations as Russia, Canada, and Brazil.

Stretched valuations. The weakness in foreign markets follows a five-year run of outperformance for international stocks. Not surprisingly, U.S. investors chased this performance by throwing billions of dollars at international stocks and funds. In fact, the only equity mutual fund segment with positive net inflows over the last three years is international. The popularity of international investments, which approached bubble status in the U.S., helped pump up valuations in many foreign markets. Thus, foreign stocks had more to give back when global markets deflated.

Of course, long-term arguments for holding foreign stocks remain valid:

-Emerging markets should continue to grow faster than the U.S. economy.

-By considering foreign stocks, you broaden your opportunity set.

-Adding foreign stocks to a portfolio should improve diversification. While it may be premature to call a bottom in foreign markets, the price correction in these markets is creating an opportunity for investors to increase their exposure. Overall, the Forecasts feels comfortable with international exposure in the 15% to 25% range for all-equity portfolios.

Mutual funds offer an easy way to diversify overseas. The Forecasts recommends three international funds:

T. Rowe Price Int’l Discovery ($24; PRIDX) focuses on small to medium-size companies in both developed and emerging countries. Although down 51% in 2008, the fund has averaged a 4% annual return over the last five years. The fund’s expense ratio is 1.21%.

Vanguard Emerging Markets Stock Index ($14; VEIEX) tracks the MSCI Emerging Markets index. The fund holds 833 stocks, with its largest stakes in Brazil (15%), Korea (13%), China (12%), and Taiwan (11%). The expense ratio is 0.37%, modest for an emerging-markets fund.

Vanguard International Value ($23; VTRIX) scouts for undervalued stocks in developed and emerging markets. Most of the companies are in Europe (66%), with the bulk of the rest from emerging markets (16%) and the Pacific (15%). The annual expense ratio is just 0.43%.

If you prefer individual stocks, the Forecasts recommends one foreign company, AstraZeneca ($39; NYSE: AZN). The British drugmaker is down 7% this year, 29 percentage points better than the S&P 500’s return. Consensus estimates project per-share-profit growth of 6% this year and next year, targets AstraZeneca may be able to exceed. AstraZeneca, a Long-Term Buy yielding 4.8%, trades at just eight times the 2009 consensus estimate.

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