But some experts worry emerging markets are overheating.

By Alan Lavine

    The declining value of the dollar and a strong global economy bodes well for foreign stocks, despite a decade of underperformance in the 1990s.
    A recent survey of investment managers by the Russell Investment Group, Tacoma, Wash., found 54% optimistic and 17% pessimistic. The rest were neutral. But some leading international investors see the growing interest and optimism surrounding this asset class as a potential harbinger of self-fulfilling problems and excessive valuations.

Meanwhile the World Bank recently forecast economic growth ranging from about 4% to almost 8% in 2006 and 2007 in developing countries and 1% to 3.6% in the United States, Japan and Euro Area countries (See table).
    Although money managers have high expectations, it's not a cakewalk. Emerging markets are extremely overvalued and due for a pullback, believes Jeremy Grantham, chief strategist and chairman of Grantham, Mayo and Van Otterloo, Boston.

In China, the greatest risk may be optimism based on country's strong economic growth. Investors overlook the risk that labor unrest poses to the country's capital markets. For example, 80,000 petroleum workers in northeast China protested wages and working conditions in 2002. Meanwhile, stocks in the China region experienced double-digit losses.

Kate Weingart, author of Working in China (AuthorHouse), says the country's labor problems are similar to those the United States experienced in the early 20th century. There have been large numbers of strikes involving thousands of people over the past few years. The reasons include: Wage inequality between rural and urban workers; benefit inequality between government and private business workers; and poor working conditions for unskilled laborers.
    "The labor problems are a risk to the financial system and the markets," says Weingart, professor of organizational leadership at Purdue University.
Another potential problem cited by analysts: Economic problems in the United States could impact the rest of the world, particularly exporting countries like China. Grantham says the real risks to the world financial markets are geopolitical or some type of crisis-not economic.
    "The biggest risk over the next couple of years is if something bad unexpectedly happens to the United States," he says. "It echoes around the world. It is not the economy, but a couple of random things that could go wrong. Then you could see a quarter with 20% losses in the foreign markets."

Such risks help explain why correlations between international stocks and the United States under normal conditions are 70%, and as high as 90% in down markets.
    Foreign stocks exhibit greater volatility in their   correlations with U.S. stocks than they have in the past, indicates a working paper by Andrew Ang and Geert Bekaert, Columbia University finance professors. The paper, International Asset Allocation with Regime Shifts, found correlations between international stock returns and U.S. stock returns tend to increase in highly volatile bear markets. So investors must monitor the correlations and make the appropriate adjustments in their asset allocation mixes.

Despite the risks, money managers say there are a lot of investment opportunities. The most attractive areas are China and other emerging markets. The Chinese economy is expected to grow at 8% to 9% over the next year.
    Meanwhile in Asia, excluding, China, low real rates, and improved banking systems should help boost consumption. Strong exports to China and Japan should support economic growth.

The outlook in Europe, however, is less exciting. Gross Domestic Product (GDP) is expected to grow just over 1% in countries that make up the euro zone. But restrained European wages should help profit growth.
    Thomas Melendez, manager of the MFS International Diversification Fund, says that emerging markets are the best place to invest. He recommends that investors keep about 5% to 8% of their portfolios in emerging market stocks.
    Nevertheless, he says that it's best to diversify internationally due to high risks in thinly traded markets.
    It's evident that many of the structural reforms enacted during the late 1990s and early 2000s in emerging markets have set the stage for growth in these economies, he says. "Corporate reforms that have taken place on a company-by-company basis have resulted in an unprecedented strength of their balance sheets."
    Another positive factor: Interest rates and inflation have declined significantly, allowing for sustainable growth in these economies as well as in many companies.Over the next 30 years, Melendez says, the economy of India is expected to overtake Germany, the third-largest economy in the world. By the middle of this century, the economies will have very technical skilled labor forces.
    "Emerging markets are trading at a 25% discount relative to the U.S. market," Melendez says. "Many of the emerging market countries have investment-grade ratings by Standard & Poor's. This is a sign of financial health."   

Some of the largest holdings in MFS' International Diversification Fund emerging market sector include:
    Samsung Electronics, one of the fund's largest emerging market holdings. It sells at just ten times earnings, but future earnings are growing 16% annually. The company is profiting from flash memory cards used in iPods and other electronics.
    Companhia Vale do Rio Doce, a Brazilian iron ore mining company. This company has been raising prices at dramatic rates due to strong demand for ore from Asia. Earnings are growing at double-digit rates.
    Tebaris, a Latin American company that makes seamless steel pipes for oil exploration. The company's revenues and profits are rising due to the strong demand for products by the oil exploration industry.
    Edmund Harris, manager of the Guinness Atkinson Asia Focus Fund, says he's finding the best investment opportunities in China.  "In the past it's been an export story," he says. "But now it's a consumption story. There are growing investments in China and the domestic economy is reaccelerating. There is growth in Chinese companies involved in infrastructure, electric production and coal mining."    

Despite his optimism, Harris also concedes risks. "The biggest risk in China lies in specific sectors of the economy," he says. "The investment boom over the past few years resulted in overcapacity and slumping margins in the steel, cement and auto sectors."
    Some of his largest holdings in China include Yanzhou Coal Mining, Petro China, Solomon Systech International and China Shipping Development. Besides China, Harris likes South Korean and Taiwan technology companies.
    Japan also looks interesting for the first in a while. The Japanese stock market has been performing well over the past few years after a decade-long slump. The banking system is stronger and corporate balance sheets have improved due to strong cash positions. Wages and employment are rising. Plus, the country is emerging from deflation. A strengthening yen spells good news for Japanese equities. But fiscal policy needs to be tightened to help solve the government debt problem.
    Grantham of Grantham, Mayo, Van Otteroo, favors Japan over other industrial and developed countries, including the United States and Europe.  "I am optimistic about Japan more than any developed country," he says. "Stocks are at least moderately cheap. There are still political risks, but the country is doing better politically. The debt and land overhang have passed."

David Herro, manager of the Oakmark International Fund, upped the fund's stake in Japanese holdings to its highest level since the 1992 inception of the fund. He still is underweighted in Japan versus his benchmark. The reason: It's hard to find shareholder-oriented management teams in Japanese companies.
    Still, Herro has been invested in several undervalued firms based on business values and cash flow since the end of 2005.  Stocks include Kao Corp., the country's largest producer of personal care and cleaning products; Rohm Co. Ltd., which makes a wide range of semiconductors; Unicharm Corp., which makes disposable diapers, feminine hygiene and adult products; Honda Corp., one of the world's leading car manufacturer; and NTT DoCoMo Inc., a mobile phone carrier with more than 50 million subscribers.

Although Asia and the Far East look good, the European markets could underperform, says Edward Yardeni, chief investment strategist with Oak Associates, Akron, Ohio. His reasons are quite contrarian: The U.S. dollar should rise against the Euro due to high unemployment and deficits in Europe. He recommends that investors reduce holdings in European stocks and stocks of U.S. multinational companies with a strong presence in continental Europe.
    Grantham disagrees. German companies, he says, could be solid investments. The country has low inflation, its exports are on the rise and it is conservative.
    Nicholas Kaiser, manager of the Sextant International Fund, says investors should not overlook Canada, Latin America and South America. Plus, he's been accumulating shares in multinational European companies with price-to-earnings multiples that are less then earnings growth rates of about 20%.
    "We are value investors going with cyclicals, mining and commodities with favorable future earnings," he says. "Canada is our biggest country exposure because of the natural resources and mining companies. We see oil prices and commodity prices holding up."