Buy Foreign!

By Daniel Kadlec

Once again the U.S. is pulling the world out of a slump. If form holds, emerging markets, Asia and Europe will play follow the eagle. So if you've been sitting on your thumbs while the Dow has soared 27% since mid-March, don't compound the error by piling into U.S. stocks now. Instead, get in on the recovery rally overseas.

Stocks of economically sensitive U.S. companies--like those in retailing, advertising, construction and technology--have risen as much as 40% since the start of summer. That run reflects expected strong growth through the next three quarters. Yes, these stocks can rally more if the recovery accelerates next year. But that's a big if, given rising interest rates and the probable softening of the key housing market.

There will be a lot of second-guessing about the economy's strength (accompanied by flat or weaker stock prices) before the market gives credit for solid growth through 2004. If you want to stay home, wait for cyclical stocks to retreat or for the economy to prove out, or focus on stocks that have lagged: defensive companies in food or health care or those with a secure dividend yield in the 2% to 5% range.

Foreign markets also have rallied, so there are no easy pickings. Even in oft maligned Japan, prices have surged. In general, though, foreign markets were beaten up worse than U.S. markets and have bounced back less. So they still promise more pop. And if the dollar weakens, as many expect, foreign holdings will rise even more in dollar terms.

How should you approach the global recovery? Europe seems most vulnerable to missing the party. Its manufacturers are plagued with high costs, and they have been struggling to restructure. Yet its stocks are priced as if all were well. Avoid this region. It's last in line anyway, and prices have to fall across the board to become broadly attractive.

Emerging markets should do well as more capital becomes available. Countries like Brazil and Russia are volatile investments, but they're a pure play on global growth and worth 2% to 5% of your stock portfolio. Consider diversified mutual funds such as Acadian Emerging Markets and Vanguard Emerging Markets.

Asia should be a core holding--not just for today but for years. Uncle Sam may be doing the heavy lifting in this rebound, "but that's less true than in the past," says George Greig, manager of the William Blair International Growth Fund. "This is a cycle where Asia and the U.S. are both leaders. The next cycle may be where Asia takes over the lead." Farsighted investors should note the powerful growth of a potentially massive middle class in China, South Korea and India--whose economies are growing 6% or more, versus just 2% or so in the U.S. As this Asian middle class develops, so will the domestic demand that will make Asia less dependent on exports and less vulnerable to woes in the U.S.

In total, this region should be 5% to 8% of your stock portfolio--easily accomplished through proven funds like Matthews Pacific Tiger and the fund run by Greig, who likes Asian consumer-electronics companies, including Samsung, Canon, Sharp, Pioneer and Taiwan Semiconductor. They have lower prices relative to earnings than U.S. tech companies, plus established export businesses and the best positioning to serve Asia's expanding local markets.

Without a recovery in Japan, the world's second largest economy, the global lift-off falls flat--and after a decade of false starts, it's hard to believe this economy is turning. Yet personal income and both consumer and business spending are suddenly surging, so believers are beginning to emerge. David Bowers, chief global strategist for Merrill Lynch, recently upgraded Japan from underperform to neutral. If the global recovery is strong, Japan's export businesses have a long way to rise, he reasons. He likes the banking sector most. Consider a fund like Fidelity Japan. Better to tiptoe into Japan for now. One of these days the turn there will be real.