Foreign Stocks Set a Blistering Pace

As the second half of the year gets underway, Wall Street's love affair with foreign investing continues to burn bright.

To be sure, domestic stocks aren't performing poorly. The Standard & Poor's 500 index of U.S. blue-chip stocks gained a respectable 6 percent (more like 7 percent if you throw in dividends) in the first half of 2007. That's more than the S&P returned in all of 2005, and it puts the stock market on track for yet another above-average year in what is turning out to be an above-average domestic bull market.

But "as good as U.S. returns were in the first half of this year, they pale in comparison to the rest of the world," says Joseph Quinlan, chief market strategist for Bank of America's Investment Strategies Group. According to a recent tally by Quinlan, the 6 percent appreciation for the S&P 500 ranks 54th out of 67 major global equity indexes in year-to-date performance.

Even if U.S. stocks were to finish the year up 10 to 12 percent, which would be good by historic standards, "the U.S. is likely to significantly underperform most of the world yet again in 2007," Quinlan says.

Most market watchers think foreign stocks will excel regardless of how the U.S. stock market performs. A recent survey by the Russell Investment Group found that 62 percent of professional money managers are bullish on foreign equities, despite the tremendous returns they've already delivered. Indeed, the average foreign equity mutual fund has racked up average annual gains of nearly 19 percent over the past five years, compared with the 12 percent returns of U.S. stock funds, according to the fund tracker Morningstar.

Emerging-markets stocks—highflying shares of fast-growing companies in the developing economies of Asia, Latin America, and eastern Europe—have done particularly well. The average Latin American stock fund, for example, has generated annual returns of more than 41 percent over the past five years—and is up 20 percent so far this year. Meanwhile, the average diversified emerging-markets fund has gained 29 percent a year for the past five years.

Why do investors think the foreign markets will continue to outslug the U.S. stock market?

Foreign economies are growing faster than that of the United States. While it's true that the domestic economy is growing at a much faster clip than was forecast at the start of this year, U.S. gross domestic product is still expanding at an annual rate of around 3 percent. By contrast, the global economy is expected to increase by about 5 percent or more this year.

Corporate profits are growing faster abroad. Despite 17 consecutive quarters of above-average or better-than-expected earnings growth for the S&P 500, global profits are rising even more. Alec Young, international equity strategist for S&P, notes that while U.S. corporate profits are expected to expand 7.3 percent this year, global earnings are forecast to grow 10.3 percent.

The U.S. dollar continues to be weak. The greenback was already trading at an all-time low relative to the euro. But now, it's also at a 25-year low against the New Zealand dollar and a 26-year low against the British pound sterling, and it's nearing a 30-year low against the Canadian dollar, notes Ashraf Laidi, chief currency analyst for CMC Markets U.S. For U.S. investors in foreign stocks, this is actually good news. That's because even if their equity holdings don't gain any value, the falling dollar will mean that they will still generate solid investment gains.

Quinlan sums up the case for foreign investing this way: "A healthy appetite for risk, stronger economic growth in the emerging markets, an abundance of global liquidity, [and] continued U.S. dollar weakness are all factors that are likely to produce returns well in excess of those in the United States." He adds that "against this backdrop, we continue to recommend that U.S. investors have at least 15 percent of their assets overseas," in assets not denominated in U.S. dollars.