Could red-hot foreign markets burn out?

Watching swings in stock markets around the world these days, you might understandably be getting anxious: Several times this summer, plunges in the US market have rippled across the seas, evidently sparking sell-offs in many foreign markets.

They have also injected uncertainty into what have been some red-hot arenas. This year alone, China's market has gained 22.07 percent, in dollar terms, according to the MSCI China index for Aug. 10. Moreover, Turkey's market has vaulted 35.58 percent, Brazil's has climbed 24.47 percent, and Peru's is up a sensational 66.59 percent, all in US dollar terms, as measured by the MSCI indexes of these stock markets.

Those returns compare with the feeble 2.81 percent return this year in the MSCI USA index. And they help explain the flood of money that's been going overseas.

Indeed, data from the Investment Company Institute in Washington show that, through the first half of this year, Americans' new money flows and exchanges into world equity stock mutual funds were more than 10 times higher than the flows into US domestic stock funds. And in 2006, these flows into foreign funds exceeded 13 times the amount that went into domestic stock funds.

But as skittishness over world markets grows, some observers are questioning whether foreign markets are still a draw. Already, markets abroad have reacted in varying degrees to the wild swings in the US market, caused most recently by lending woes.

All the while, some foreign central banks are in the throes of tightening monetary policy, thereby boosting local interest rates, which could slow economic growth. And on the valuations front, some worry that markets may be getting pricey after their breath-taking gains.

Such issues would certainly concern speculators, who might be expected to flee markets that appeared to be headed down. No one knows how much of the money heading abroad is speculative and how much is there for the longer term. But quite a few market pros believe much of the deluge going abroad in recent times has been so-called hot money.

"A lot of this money is chasing returns, particularly in the emerging markets, where we've seen four years of 30-plus percent returns," says Nate Krogman, an investment consultant at Hewitt Investment Group in Lincolnshire, Ill. "Individuals sometimes forget about the volatility in these markets ... and I think they'll be quick to leave if returns" in those markets soured.

But many Americans have been measured in their foreign investments, not simply lunging at hot markets and riskier holdings, such as country-specific funds. Last month, Morningstar's list of funds with the highest net inflows through May found that the top three "were all international, and were all familiar names: Dodge & Cox International Stock; American Funds Capital Income Builder; and American Funds Capital World Growth & Income." Morningstar considers each of these to be diversified funds.

Such funds are not immune to downturns. But they are perceived as safer bets than buying individual stocks or single-country funds. And to some observers, the appeal of such broader funds suggests that at least some investors are seeking portfolio diversification, as well as good returns, from foreign holdings.

"Financial advisers are recommending much higher allocations abroad and investors are taking their advice," says Avi Nachmany, research director at Strategic Insight in New York City. "Everyone is looking for what to buy globally." As he sees it, the impetus to invest abroad "is irreversible."

The financial planning firm of Kochis Fitz in San Francisco has always encouraged clients to invest overseas, reports Kacy Gott, a principal at the firm. And evidently, the advice has been taken to heart.

"Over half of our clients have all-equities portfolios, even retirees. And over half of the clients have more than 40 percent – of their entire portfolio – in overseas equities. That's based on our recommendation," he says.

Today, he says, international investing is an easier sell than it was in the mid-1990s. Educating clients now takes much less time, as clients witness the increasingly global nature of business, get better information about world economies today, and observe the "easier flow of money around the world," Mr. Gott says. "People feel if they're not participating overseas, they're missing something important."

Gott believes this attitude is "permanent." "The professionals we know and deal with around the country are much more in agreement with this [long term view on foreign investing] and are less likely to lead their clients back and forth, in and out, of foreign markets."

But investment practices notwithstanding, questions do arise as to whether to put money abroad now. Have the markets abroad started looking tired and spent?

For his part, David Herro, Chicago manager of the Oakmark International Fund, doesn't seem wildly enthused right now. "I don't think foreign stocks will do poorly. But the [degree of] outperformance of the last five years will not be repeated" in the coming years, he says. "At this stage, the currency tailwind could go away and turn into a headwind, since the dollar is looking undervalued" versus foreign currencies.

And although foreign "companies should continue to earn profits," he says, "the differential in valuations that existed five to six years ago is not as pronounced today."

Thus, "people shouldn't jump on the [international] bandwagon now," Mr. Herro warns – although "they should have some foreign exposure."

But the current turmoil in stock markets sheds light on the need to be invested outside the US – and in a broadly diversified way, says Somnath Basu, director of the Institute of Finance at California Lutheran University in Thousand Oaks, Calif. "Being dependent on a single market at this time would be a very dangerous thing. It would be like putting your whole portfolio in a single company," he says.

Mr. Basu believes that now is "a good time to get into as many world markets as you can."

And to John Chisholm, co-chief investment officer at Acadian Asset Management in Boston, market returns from abroad still look relatively favorable – if not as stellar as in recent years. Over the next five years, he figures European markets should produce 10 to 11 percent annualized returns, with world markets gaining an annualized 8 percent, and the US market posting a lesser 7 percent annualized return over that period. Thus, from a returns perspective, Mr. Chisholm believes "there still is a reason to stay invested" overseas.